Is an interest-only loan worth it or something to avoid?

A new Australian Prudential Regulation Authority (APRA) crackdown on interest-only lending has shined a light on a loan product popular with hundreds of thousands of Queenslanders.

But are interest-only loans as bad as the regulator would have us believe or are they a useful wealth creation tool?

It depends, according to the experts.

Interest-only loans can be beneficial if they assist with an initial purchase to improve cash flow to fund property.

Interest-only loans make sense for investors, Metropole Wealth Advisory Director Ken Raiss says, as it improves cash flow which can be used to generate wealth.

“Paying off principal as an after tax-payment is a very poor method of wealth creation,” Mr Raiss says.

“It’s better to use funds to secure additional investments, which will eventually reduce social security needs.”

When paying interest and principal, the significant bulk of payments in the first few years is basically only covering the interest

Interest-only loans are common with investors because it’s the interest repayment component that is tax deductible, Mortgage Choice CEO John Flavell says.

But they can be dangerous in the hands of someone without the financial discipline to manage them correctly, he says.

This was especially so for homeowners who used interest-only loans due to affordability reasons.

Interest-only loans can save cash flow for improvements and/or renovations.

“No borrower should choose an interest-only loan simply because they cannot afford to make the principal and interest repayments on their loan,” Mr Flavell says.

“Owner occupiers who have an interest-only loan are effectively not paying down their principal mortgage debt. As such, they exit the interest-only period and still have paid nothing off their home loan.”

It is important for owner occupiers to understand that interest-only loans are short term mortgages and repayments will increase once the interest-only period ends, Mr Flavell said.

While there is currently a crackdown on interest-only loans, Mr Raiss doesn’t believe borrowers would have too much trouble if principal repayments were instigated, because those who borrowed responsibly should have used the additional cash flow from interest-only repayments to their financial benefit, either through further investments or increased savings.

“We all need a place to live, so there will be increasing housing pressures…even if property prices severely fell, then a bank could ask for increased repayments to maintain the loan to value ratio and it could be funded by the savings people made when on interest-only,” he says.

Mr Raiss says interest-only loans were popular with other forms of finance including car loans, which had a balloon payment at end of the period, and land and house packages where only the interest was paid during the construction phase.

Source: www.domain.com.au

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Is an interest-only loan worth it or something to avoid?