May 18, 2016

Interest Only Loan

What is an interest-only home loan?

An interest-only mortgage is more or less what it says on the can: it?s a home loan where only the interest is paid, rather than both the interest and the principle.

This type of loan can be useful for investors who can claim the interest as a tax deduction, or buyers who only plan on holding onto the property for a few years before selling it. Interest-only home loans may not be a good idea for standard home-buyers simply looking to pay less on their weekly repayments, because the smaller the amount of loan principal that is paid off, the more overall interest you may end up paying on your loan over the years.

Can help maximize tax deductions

An interest only home loan generally presents potential benefits to investors. If the interest paid on the home loan is a tax deduction for the investor, then paying interest-only enables the investor to maximize that deduction. After all, paying off the principal means that interest would be charged on a smaller amount. This in turn reduces the dollar amount of the tax deduction.

An investor may take out an interest-only mortgage on a property, and count on appreciation of the property to pay the principle at the end of the term.

Who Should Consider An Interest Only Loan?
The borrower may consider an interest only mortgage if they:

Desire to afford more home now.
Know that the home will need to be sold within a short time period.
Want the initial payment to be lower and they have the confidence that they can deal with a large payment increase in the future.
Are fairly certain they can get a significantly higher rate of return investing the moey elsewhere.
Advantages Of Interest Only Loans
There are pros and cons with each different type of mortgage. The advantages of having an interest only mortgage loan are:

Monthly payments are low during the term.
The borrower can purchase a larger home later by qualifying for a larger loan amount.
Placing extra money into investments to build net worth.
During the interest-only period, the whole amount of the monthly payment qualifies as tax-deductible.
Disadvantages Of Interest Only Loans
There are some drawbacks to interest-only mortgage plans. These disadvantages are:

Rising mortgage rates increases risk if it’s an ARM.
Many people spend extra money instead of investing it.
Many cannot afford principal payments when the time arrives and many are not disciplined enough to pay extra toward the principal.
Income may not grow as quickly as planned.
The home may not appreciate as fast as the borrower would like.

Typically the interest-only term is five years, with an option to extend for five years more. After the interest-only term the loan reverts to a standard P&I loan, but the repayments are amortised over the remaining years.
So if you take a five-year interest-only term in a 25-year mortgage, when the loan reverts your subsequent repayments are for a 20-year P&I mortgage. If you extend the interest-only loan for another five years, after it reverts the remainder of your 25-year loan becomes a 15-year P&I mortgage.

In best practice, this is how an interest-only loan is used: a couple with a P&I loan on their primary place of residence, borrow to buy an investment property. Their investment loan is interest-only because the interest is the only part of the finance costs in an investment property which is tax-deductible.At the same time, the couple has non-tax deductible debt in their family household: their mortgage, their car finance, their credit cards. So the couple use their income to pay-down their personal non-deductible debt, while they only service the tax-deductible component of their investment property debt: the interest. Most couples would start paying-down the personal debt with the highest rate (typically the credit cards), and move down the scale of interest rates, to the mortgage.
When the interest-only loan reverts the borrowers might decide they can't afford the P&I mortgage, and they sell the property or they refinance the loan.

would the tax deduction be higher than the extra interest rate

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