Interest-only loans can prove costly

SEPTEMBER marks the start of spring, and the weather isn't the only thing likely to heat up over the next few weeks.

Spring is traditionally the peak period for real estate, and comparison site Finder estimates over 160,000 home loans could be taken out between now and November by first home buyers, investors and upgraders.

If you could be among the buyers it pays to shop around for your loan. Interest rates may be at record lows but there are still big variations in the cost of mortgages offered by different lenders.

It also pays to think about the type of loan you choose. According to money watch dog - the Australian Securities and Investments Commission (ASIC), demand for interest-only loans has grown by around 80% since 2012. This is partly a result of strong investor activity though it also reflects increased numbers of owner occupiers opting for interest-only loans.

That's quite a turnaround from previous years when interest-only loans were used almost exclusively by investors. A key difference is that today's home buyers often face very high property prices, and choosing to make interest-only payments can, on the face of things, make a loan appear more affordable. However, for owner occupiers this is likely to be a case of false economy.

With an interest-only loan the regular payments don't include any repayment of the principal. So assuming the same rate, the monthly payments should be far lower. On a $500,000 loan with a rate of 5% for instance, interest-only payments would be about $2,083 each month versus $2,922 with a principal plus interest loan. That's a difference of $839 each month, which could be a deal breaker for some buyers.

The catch is that without any repayments of the loan principal, interest-only borrowers are continually paying interest on the full value of the loan. And that could see you paying considerably more in interest - even over short periods - than with a traditional loan.

As a guide, ASIC crunched the numbers and found that on a loan of $500,000, making interest-only payments for just five years can add an extra $37,000 to the long term cost of the loan.

The bottom line is that interest-only loans can work for investors.

As an owner occupier, I strongly recommend sticking with principal and interest payments.  It means owning your home debt free one day and also saving on overall interest costs.

Paul Clitheroe is a founding director of financial planning firm ipac, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.

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