Interest-only home loans may come at a cost

You can now delay repaying the capital on your home loan until it matures. While this repayment option has advantages in certain circumstances, you need to weigh these against the potential risks.
September 23, 2006

By Charlene Clayton

Paying only the interest on your home loan may alleviate your cash flow problems in the short term, but it may have serious consequences.

SA Home Loans recently launch-ed a feature on its loans that allows you to service only the interest on your home loan - for the full 20 years of your loan term if you wish.

Interest-only loans are risky because the "spend now, pay later" premise of the product could result in many people landing in deep financial trouble, Gavin Opperman, the managing executive of Absa Home Loans, says.

Richard Sparg, a Certified Financial Planner (CFP) and chartered accountant at Cape Town financial planning company Netto Financial Services, says the risks of not paying any capital on your home loan until the end of your loan term are:

• You remain in debt for longer.
• If interest rates increase, you will be in a worse financial position than if you had been repaying both the interest and capital on your loan. This is because the interest component of a loan decreases over time if you repay both the capital and the interest components every month. But if you are paying only the interest in an environment of increasing interest rates, your interest payments will increase.
• You will ultimately have to repay the capital on your home loan, and with the average home loan at about R500 000, forking out this amount in one go can make quite a dent in your finances.

"Few retirees have R500 000 lying around," Ian Beere, another CFP and chartered accountant at Netto Financial Services, says. If you do not have the cash available, you may have to sell assets in order to settle the loan.

Beere adds that paying interest only is never suitable for people who do not live within their means, because it will rob them of net asset growth in the long term.

"Most people get to 65 years and their only assets are their retirement fund savings and their home, which is fully paid," Beere says.

Opperman says homeowners who opt for interest-only loans can't build any equity early in their loans and thus rely on an appreciation in their property's value to help them "own" more of their homes.

This is all very well in a robust market, he says, but when property prices start coming off the boil, homeowners could end up owing more than they own. And if, for whatever reason, the homeowner needs to sell the property while paying the interest only, the homeowner may be responsible for the selling costs, Opperman says.

While these costs can be paid out of the home equity, the homeowner may be in financial trouble if he or she has not contributed to reducing the capital, he says.

Beere and Sparg say there are five instances in which paying interest only on your loan may be an advantage, but they are not without risk. The five instances are:

• First-time homeowners. Paying interest only on a home loan for a few years can assist the cash flow of first-time homeowners, who are usually cash-strapped because of all the expenses associated with buying a new home. But, Beere says, first-time homeowners must commit themselves to making full monthly repayments as soon as they can.
• Irregular cash flow. Interest-only options on a home loan may be useful for people, such as commission-earners, who do not receive a regular income.
• Investment properties. The rental income you receive from a property is added to your salary and any other sources of income, and will thus increase your tax liability.

When you own an investment property with the aim of achieving capital growth, you should keep your taxable income as low as possible. On an investment property, you enjoy a tax deduction on the expenses that you incur in holding the property. This includes deducting from the rental income the interest you pay on a loan on the property.

By keeping the loan at its maximum level, you will be able to claim the maximum tax deduction. An interest-only mortgage bond will allow you to deduct more interest over time.

• Tax-efficient retirement savings. If you are disciplined enough, you can use the extra cash you save by repaying only the interest on your home loan to invest in a tax-efficient savings vehicle, such as a retirement annuity (RA).

You can claim a tax deduction on contributions to an RA up to certain limits. The tax is limited to 15 percent of your non-retirement funding income, or R3 500 less your current deductions to a pension fund or R1 750, whichever is the greater.

• Diversification. If the only asset class in which you are invested is property (your home), it could be argued that by investing elsewhere, say, in a balanced unit trust fund, you would be diversifying your investments across asset classes.

But, Sparg says, you would have to achieve an annual after-tax return of at least 10 percent from the unit trust fund (assuming the interest rate you are paying on your home loan is 10 percent) to make this worthwhile, and you would need to weather the ups and downs of the markets.

• Paying off more expensive debt. If you are paying off other debt at a higher interest rate than that on your home loan, it may make sense to use the additional cash to service this debt.

Normal vs interest-only repayments
The normal monthly repayment (interest and capital) on a loan of R500 000 at an interest rate of 10 percent a year over 20 years is R4 825 a month.

With normal monthly repayments, you will pay R658 000 in interest. So, in total, the loan will cost you R1 158 026 (capital of R500 000 plus interest of R658 026).

On the other hand, if you service only the interest on your R500 000 loan (also at 10 percent a year over 20 years), you will end up paying R1 million in interest. This is because you pay interest on a capital amount that never reduces. At the end of the loan term, servicing only the interest on the loan will cost you a total of R1.5 million (capital of R500 000 plus interest of R1 million).

If you pay the interest only on the loan, you will have an extra R658.44 in your pocket each month, because your monthly repayments will be R4 167, as opposed to R4 825.

Over 20 years, this saving will result in a total additional cash flow of R158 026.

At the end of the 20-year term, you will have to repay the capital of R500 000, but in 20 years' time, assuming an inflation rate of four percent a year, the R500 000 will be worth R224 963. The higher the inflation rate over the 20 years, the lower the capital that you would have to repay, would become.

A sum of R500 000 in 20 years at an assumed inflation rate of five percent over the period, would be R184 322. And at an inflation rate of six percent, R500 000 would be worth R151 048 in 20 years' time.
(Persfin,September 23, 2006)

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