As interest-only home loans and term extensions are often permitted to be availed for just a short-term period, the main reason to consider one is to reduce your monthly mortgage payments for a set time frame. Image Credit: Shutterstock

Dubai: If you're struggling to meet your monthly repayments on your home loan, you may be given a choice to either temporarily switch to interest-only payments or extend your existing mortgage term. But which of these options would you choose? Also, how will this affect your credit score?

”Even though they are not as common as traditional mortgages, ‘interest-only’ home loans are often opted for when there is a cash crunch at the time of applying for a loan. But there are risks involved,” explained Abbud Sharif, a banking industry analyst based in Dubai.

How are traditional home loans different from ‘interest-only’ ones?
‘Repayment mortgages’ are traditional home loans that involve paying a set amount each month for the duration of the loan. The payment comprises an amount partly allocated to paying interest (the cost of borrowing), with the rest making up a portion of the borrowed amount (the principal).

However, with interest-only mortgages, you pay just the portion of interest each month, with the whole principal amount expected to be paid in full at the end of the term. So, if you find it hard to at first to shell out much every month to pay your dues, such loans are worth considering.

How do ‘interest-only’ home loans work for you?

“How long you get to pay just the interest portion on ‘interest-only’ home loans depends on the length of your mortgage and how much you borrow,” explained Jose Paul, an Abu Dhabi-based banker. “After which, you will need to start to pay off the principal amount due.

“In the past, borrowers might have sometimes successfully paid off their interest, but have then reached the end of their loan and have been unable to pay off the principal amount. This is why these loans are risky, and why they are often only available with terms of five years.”

Sometimes, your lender will offer you the option to pay off part of the principal during the initial interest-only period. Whether or not you opt to do this will depend on how you plan to exit the loan, your financial situation and how useful this would be to you from a planning perspective.

Here’s an example of when such loans can benefit
If you took a traditional 13-year repayment home loan of Dh1 million with an interest rate of 4 per cent, the monthly repayments would be Dh6,680. This amounts to Dh80,160 annually. If you took the same mortgage amount and interest rate, but on an interest-only repayment basis for the first year, then the monthly repayments would be Dh3,333.

Over the course of a year this would amount to about Dh40,000. In this case, opting for the interest-only mortgage for just one year would amount to a saving of Dh40,000. While this will benefit you the first year, it won’t be as beneficial in the long run given the end-of-term charges for such loans. Apart from charges, interest-only mortgages also often require a much higher down payment.

What are the risks of interest-only mortgages?

“Interest-only loans typically require a larger down payment, higher credit score and a lower debt-to-income (DTI) ratio than conventional loans. The debt you can take on proportional to your income is a measure used by lenders to determine a borrower’s ability to repay the loan,” added Sharif.

“While interest-only mortgages can be a great choice for some borrowers, their high down payment requirements and end-of-term charges make them less of an attractive option. Also, it may not be easy to qualify, as you will need to prove to the bank your repayment capability.”

Sharif further explained that another risk with interest-only loans is if your property loses value, while you are not repaying any of the principal, then you could end up owing more than it is worth, possibly requiring you to sell for a loss.

What conditions come with interest-only loans?
The option to switch your mortgage to ‘interest-only’ often lasts for only up to six months. After this your mortgage payments will revert to normal (plus a subsequent fee for choosing this option).

There's no affordability check either when you apply, or when your mortgage reverts to normal. So, opting for it and switching back should be smooth.

There should be no adverse impact on your credit file. Other lenders will likely see your mortgage repayments are smaller, but there'll be no information on your file to suggest why.

What if you need help for longer than six months?

“If you need more than six months of help, consider extending your term instead as this isn't time limited. While your lender may permit you an interest-only loan beyond the initial six months, this can have an impact on your credit,” added Paul.

“By extending your mortgage term for six months (or longer), you choose how long to extend your term by. For example, you could increase your remaining term from 10 to 15 years (though you can't extend it indefinitely). The longer you extend by, the more your monthly payments will reduce.”

However, Paul added that while extending your mortgage term will lower your payments, it’s not by as much as switching to interest-only loans. “The bigger your balance, the bigger the impact of any extension. Also, the more you extend your term by, the more this will reduce your repayments.”

Key takeaways: When to consider ‘interest-only’ loan or term extensions
As interest-only home loans and term extensions are often permitted to be availed for just a short-term period, as mentioned earlier, the main reason to consider one is to reduce your monthly mortgage payments for a set time frame.

“While interest-only mortgages or term extension are good options when you experience issues with cash flow, the lower monthly repayments will also allow you to be more flexible with your spending, whilst still meeting the commitments of your mortgage,” said Sharif.

“An interest-only mortgage can also help if you’ve recently purchased a property and are looking for new tenants to rent the property. In the time between completing the mortgage and finding tenant rents for your property, an interest-only mortgage can help keep your investment to a minimum.”

Bottom line

So is it better to choose interest-only home loan or extend its term?

To decide which of the two options is better for you, Paul said that going ‘interest-only’ likely wins if you need a significant amount of short-term help. “That's because it generally reduces your monthly bills by a greater amount.

“However, you pay for it in the long run, as it will likely add more to the total cost of your mortgage. The other big disadvantage is that this help is short term. Extending your term likely wins if you need a small amount of short-term help or if you need longer-term help.”

Sharif agreed with Paul that even though extensions don’t usually reduce your monthly payments by as much as going interest-only, it won't add as much to the total cost of your mortgage during the first six months.

“The other key advantage with extending your home loan term is that it's more flexible – as it can last for longer than six months if needed. This makes this option as a clear winner if you are looking for longer flexibility on your payments,” Sharif added.