Interest-Only Loans: The Pros And Cons

Source : The Business Times, 14 Nov 2007

They make sense to short-term investors and individuals who are high income earners and in high tax brackets, says BEN FOK

CONSUMERS are constantly bombarded with offers of loans, overdrafts, credit cards and instalment plans that promise instant gratification.

We cannot avoid debt entirely, especially when it comes to acquiring the big ticket items, and not all debt is bad. But those who borrow must be prudent and know that they can make the repayments.

Even high net worth individuals (HNWI) go to financial institutions for loans, which might seem strange since they are presumably cash-rich. But there are situations where it is worthwhile for the HNWI to borrow instead of paying with their own cash.

Some financial institutions offer interest-only loans targeted at the HNWIs. With such loans, you only repay the interest, not the principal, so the loan balance remains unchanged. Most interest-only loans offered by financial institutions are associated with the purchase of property.

Interest-only loans make sense to individuals who are high income earners and in high tax brackets. The benefit comes from being able to save on tax on rental income. That's because the interest portion of loan instalments for rental properties is tax deductible.

This package also works well for short-term investors. By repaying only the interest, investors fork out less cash each month, until they sell the property. As a result, they may be able to invest in two properties instead of one.

But interest-only loans are not for the long term, because at the end of the loan period, the payment is raised to the fully amortising level. If you're still in your home at the end of the interest-only period, you'll have to start paying off the principal. The payments will be considerably larger because they'll be amortised over a shorter period. For example, if your interest-only option lasts for five years and you have a 30-year loan, your principal payments will be calculated on a 25-year term.

Drawbacks of interest-only mortgages:

You could experience payment shock. As mentioned earlier, your monthly payment will go up - sometimes by 30 per cent or more - when you start paying off the principal. And if the end of your interest-only period coincides with an upward adjustment in your mortgage rate, you could face an even sharper hike in monthly payments.

You're more vulnerable if your home value declines. Many borrowers with interest-only loans assume home price appreciation will help them build equity in their homes. In recent years, that's been a good bet. But rising interest rates could deflate real estate values in some high-cost areas.

It's best to get a reputable financial institution to run the numbers for you and spell out the worst-case scenarios.

Equity provides a cushion against falling home values. Without it, you could find yourself owing more on your mortgage than your home is worth. If you sell, the proceeds won't cover your loan balance, which means you'll have to come up with money from another source. One way to avoid this problem is to make a good-sized downpayment on your mortgage.

Advantages of interest-only mortgages:

You have more flexibility. Some interest-only borrowers can afford a larger mortgage payment but their priority is to beef up their retirement nestegg or build up their emergency funds. Once they've accomplished those goals, they often decide to increase their mortgage payments.

Increasing your monthly payments will build equity and lessen payment shock when you're required to start paying off the principal. If you're interested in this option, make sure your loan doesn't contain pre-payment penalties.

Interest-only mortgages are complicated, so make sure you understand the pitfalls before you sign anything.

And don't rely on the financial institutions to figure out how much you can afford to borrow. A lender may not take into account all of your future expenses, such as child's university fees or support of an elderly parent.

What worries me is Singaporeans taking two or more mortgages in a rising market. As property prices rise, the dollar amount also rises in line with higher selling prices. Affordability becomes an issue. You're in the best position to know what your financial obligations are, so get a mortgage you can afford. How much should one borrow? There are two ratios that financial advisers commonly use:

Debt to asset ratio which is total debt/total assets. This ratio should be 50 per cent or less;

Debt servicing ratio which is total monthly loan repayment/monthly take-home pay. This ratio should be 35 per cent or less.

After all, wealth equals assets less debt. It is built up over the years by accumulating assets and paying down debt, especially mortgage debt. When you pay down the balance of your mortgage, you are increasing your wealth by reducing debt. But an interest-only mortgage does not increase wealth in that way.

Of course, you may be increasing your wealth by accumulating assets instead. If that's your plan and you have determined that it is more effective in building wealth during the interest-only period than paying down mortgage debt, fine. But paying down mortgage debt is the most effective way to build wealth, especially in today's financial environment. Four dangers related to borrowing too much:

# It can become a habit;
# It takes away money from other important needs;
# Your credit rating will be damaged if you don't pay the bills;
# It can lead to high interest payments that are harder to make.

Three situations where it's better to avoid borrowing:
# Paying your everyday expenses;
# Covering optional spending;
# Borrowing when you know you can't afford the payments

It's not a good idea to borrow a lot thinking that you will just pay the minimum back each month. It may take a long time to get out of debt and you'll end up paying a lot of interest. Also, if you have one late payment, your credit rating may suffer and you'll be charged penalties.
At the end of the day, paying down a loan is the best option, because once it's paid it remains paid.

Ben Fok is CEO, Grandtag Financial Consultancy (Singapore) Pte Lt.