Buying your first home is an exciting time. You may have spent years saving for a deposit and then months searching for the perfect property. But buying your home can also be stressful as there is so much involved. It can also be time consuming and even confusing when it comes to financing your purchase. It is important to make good decisions as paying off a mortgage is a long-term investment. Making home loan payments for 25 to 30 years takes dedication.
What type of mortgage is best for you? An interest only loan or one where you pay off the principal and interest right from the start?
Let us explore the options to give you better insight into the world of mortgages. This will help you set up the right type of repayments from the start and save as much money as possible on mortgage repayments.
There are two main types of home loan repayments — interest only and principal and interest, P&I for short.
Interest only Home Loans
With an interest only home loan, you only pay the interest calculated on the principal owing every month. This is usually for a fixed period for up to 5 years. During this time the principal amount you owe does not reduce unless you opt to make extra repayments into your mortgage account.
Usually investors take out interest only loans, but your lender may allow it in some situations. Before deciding to make interest only repayments, here are some benefits and drawbacks:
Lower monthly repayments. Suddenly you may find yourself without a job or things change for the worse financially. Talk to your lender about only paying the interest to reduce your monthly repayments. For example, on a $400,000 loan you may be paying $1,751.82 a month paying principal and interest. By switching to interest only, the monthly repayment will be $1,190 which will save you $561.82 a month. This can give you the time you need to get back on track financially.
Manage outgoings. As a first home buyer, paying only the interest at the start of your mortgage can help you manage your outgoings and expenses for a few years. It gives you the opportunity to improve your financial position after all the costs associated with buying a home.
Tax advantages. There may be tax advantages for investors as they can claim the interest as a tax deduction. This can free up other resources to invest into other opportunities. Normally new home buyers are buying to live in their home rather than as an investment so there are no tax benefits.
Eventually repayments are higher. Once the interest only period ends your repayments will become higher. For example, on a $500,000 loan, the interest payments will be $1,375.00 per month, based on a 30-year mortgage. The repayments will go up to $2,449.81 a month for the remaining 25 years once the interest only period ends.
Costs more over the life of the loan. Paying interest only means you will pay more over the life of the loan as you are charged interest on the total amount you owe while you pay only the interest.
Takes longer to increase equity. It takes you longer to increase equity in your home because you are not paying off any of the principal. This means that how much you actually own of your property remains the same while you are paying just the interest portion.
Interest Only Home Loan Scenario
Imagine this scenario. You have a new mortgage to pay off over 30 years and you pay interest only for the first 5 years. The interest rate is 3.3% so your interest only payment is $1,190 a month. By making the minimum repayments, you will still owe $400,000 after 5 years. Now you only have 25 years to repay that amount so your monthly repayments will jump to $1,959.85 a month. That is $769.85 more you need to find every month. This makes the total interest you pay over the life of the mortgage $253,954.
In contrast, shown in the later scenario, the total interest payable over 30 years would be $23,298 higher than the P&I loan option.
You can see how interest is calculated using an interest only loan calculator.
Principal and Interest Home Loans
Principal and interest mortgages are the most common type of loans that lenders offer new home buyers. With these loans, your repayments include paying off part of the principal borrowed as well as the monthly interest the lender charges. So right from the start, you pay part of the amount you borrowed (the principal) as well as the monthly interest owed.
While this means your repayments are more than interest only repayments, you grow equity in your property quicker. This progressively reduces the amount of interest you pay over the term of the loan.
When you receive your mortgage contract, make sure you read it. Your lender will have calculated the monthly repayments over the life (or term) of the loan which is usually no more than 30 years. This means that you have to pay off the full amount you borrowed, and the interest owed in this time.
Before deciding whether principal and interest payments are right for you, here are some benefits and drawbacks:
Pay less interest. Because you are paying off the interest on the principal amount you borrow every month, you will pay less interest over the life of the loan than you will when paying interest only.
Interest rate may be lower. The interest rate may be lower when your repayments include principal and interest. Why? Lenders see you as less of a risk and may offer you a better interest rate.
Increase equity faster. You will pay your loan off faster, so you earn equity in your home faster. This means it takes you less time to own your home than if you pay interest only.
Repayments are higher. When paying off the interest and principal, the repayments will be higher than only paying interest each month.
Tax deductions become more complicated. If you are an investor, you may still be able to make tax deductions but only from the interest portion of the repayments. This becomes harder to identify, however a good accountant can easily work this out on your behalf.
You can see how interest is calculated using the home loan repayments calculator.
Principal and Interest Home Loan Scenario
Now let us compare paying the principal as well as the interest right from the start of your mortgage. So, you have a new mortgage to pay off over 30 years and you pay off principal and interest every month. The interest rate will be 3.3% so your monthly payment is $1,751.82 and will not change for the life of the loan unless you refinance or make an agreement with your lender. The total interest you pay is $230,656. Paying principal and interest reduces the total interest amount payable by $23,298 over the life of the loan compared to making interest only repayments for 5 years. With this type of mortgage you pay off the monthly interest along with the principal, and the amount of interest you pay monthly reduces over time.
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