I wanted to tackle the topic of going interest only on your home loan temporarily and why some people opt to do this.
We all know that a home loan consists of ‘principal’ and ‘interest’. The principle is the amount that you pay towards your home loan that reduces the actual debt itself. The interest is the charge you pay for the privilege of being lent money by the bank, which doesn’t reduce the principal.
There can be many reasons that someone would opt for an interest only home loan,
Depending on how far into your home loan term you are, going interest only will see you stop paying the principal, in turn releasing a chunk of cash that would otherwise go towards paying off your debt.
Here are some considerations and thinking around the pro’s and con’s of going interest only on your home loan.
Remember, you should always seek financial advice before acting upon any ideas you might have. There are numerous reasons why you shouldn’t go interest only on a home loan at the bottom of this article.
Why go interest only on a home loan?
Here are some of the common reasons that people opt to go interest only for a while on their home loan.
Use the money to pay off bad debts
Sometimes people have bad debts, like a credit card that continues to linger and cost a bomb in interest.
If you have a loan or credit card that is attracting interest rates that are detrimental to your personal finances, people often consider going interest only in order to redirect that money towards the bad debts.
While this means your home loan will last longer (because you aren’t paying principal) – you are potentially repaying a loan that is going to cost you significantly more in the long run.
Example: I personally had a ‘consolidation loan’ that I took out to repay a bunch of credit cards years ago after I got married. The loan seemed to never go down, not because I was redrawing from it, but because I was making minimum repayments. I didn’t want this loan to last the full 25 years of my mortgage length, so I opted to redirect my cash flow from my primary mortgage to this consolidation loan.
Outcome: This allowed me to repay my ‘bad loan’ in 1 year rather than 25 and save a tonne of interest by doing so.
Use the money to invest elsewhere
Quite often people are unable to invest in shares, managed funds or other sources of investments because they are cash flow poor from repaying a mortgage.
Some people decide to go interest only on their home loan to then use the principal portion of their repayments to invest.
The hope here is that the returns they receive on their investment are better than the interest they would save by repaying a home loan.This method is very risky and is not for amateur investors – you should always seek financial advice before deploying strategies like this.
Example: I have a friend who went interest only on his mortgage and used the money to invest into shares. He did so not because he thought he could beat the market or get a better return than his mortgage, more so that he was sick of feeling like he had no diversity in his investments (outside his house).
Outcome: He went interest only for a year and built a substantial share portfolio (at the expense of paying off principal on his home loan). I have no idea if he will do better over the long run, but I do know he was able to achieve his goal (for better or worse) and now has a portfolio of shares he would otherwise never of afforded.
Use the money to help free up your cash flow at important times in life
Another popular reason that people turn to interest only on their home loan is when important or significant life changes occur. This may be the birth of a child, a change in employment, redundancy or even an illness in the family.
Through going interest only, people can then use the money elsewhere, directing it towards immediate financial concerns.
This is quite often done as less of a wealth building strategy and more of a temporary ‘holding strategy’ where by the newly created cash flow can help to preserve something or fund a moment of significance (like buying baby goods, which are expensive!).
Example: A friend of mine was made redundant. They were given a lump sum of money and that was to help cover their costs while they found another job. While the looked for another job, they opted to go interest only on their home loan in case the job hunt took longer than the money would last.
Outcome: This reduced their repayments and preserved the money, in turn making it last longer. Luckily for them they found a job, that paid better, and decided to go back to principal and interest and celebrate by depositing the remaining lump sum onto their mortgage, putting them a few months ahead of repayments.
Get the money ready for withdrawal for investment reasons
Sometimes people who plan to buy a second house, will set their home loan to interest only and pair it up with a 100% offset account. This means they only pay interest but can still put the ‘principal portion’ into their offset account and reduce their debt.
This is much the same as a normal home loan in that you will pay less interest if you continue to deposit the principal into your offset. The key point of difference is at the drop of a hat, without selling the property – you can redraw the principal in total and use the money.
Example: People do this in order to maximise the negative gearing losses they intend to make.
Outcome: People withdraw the money off their loan once it is rented out. This makes higher interest charges and in turn greater losses, resulting in a bigger tax refund.
Things you need to be careful of when you go interest only
When paying interest only, you are effectively ‘standing still’ on home loan repayments
Remember that by paying interest only on your home loan, you are not repaying the principal and in turn not getting any closer to paying off your home loan.
You are effectively standing still. Some people do this as an actual strategy, hoping to hold their house and then sell for a profit while paying only interest in the short-to-medium term.
One of the easiest ways to force yourself to save money and get ahead financially (hopefully) is to repay your mortgage, both principal and interest. One day you will hopefully own the house outright and that asset itself will be very valuable (pending how the housing market goes).
Be careful not to over commit to expenses during interest only time
Some people go interest only and then believe the newfound cash flow is actually real money they can assign to expenses. They think this money is part of their budget, when really it is part of their budget but at the sacrifice of making ground on your home loan.
Final word on going interest only on your home loan
Never forget why it is you went interest only and the money you free up from doing so should go 100% towards the task you have decided on.
If you went interest only to help gather money to repay a credit card, be sure that every cent goes towards the cause and you immediately revert to principal and interest once you achieve your goal.