Dubai: 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. Let’s look at them in detail.
‘Repayment mortgages’ are traditional home loans that involve paying a set amount each month for the duration of the loan. The payment comprises of 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 long you get to pay just the interest portion depends on the length of your mortgage and how much you borrow
How do interest-only home loans work for you?
“How long you get to pay just the interest portion depends on the length of your mortgage and how much you borrow,” said Abu Dhabi-based consumer credit analyst Rajesh Markara. “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.
When you should consider an interest-only loan
As interest-only home loans 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 an interest-only mortgage is a good option 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 Dubai-based debt consultant Rupesh Naish.
“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.”
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 Markara.
“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.”
Markara 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 actually worth, possibly requiring you to sell for a loss.
How else you can qualify for an interest-only mortgage
So how can you qualify for an interest-only mortgage? In a lot of cases, borrowers looking to opt for such loans typically need a credit score around 680 or higher to qualify, which is a score that’s higher than average.
“Lenders also require proof of income and charge several fees to make sure borrowers understand the risks before taking out the loan,” added Naish. Additionally, with borrowers now having shorter loan terms, they have to start paying the principal of the loan sooner than before.”
“Interest-only mortgages are better suited to borrowers with lots of cash in reserve; borrowers who see their income significantly rising in the near future; and those disciplined enough to redirect income spikes toward paying down the principal.”
Lenders also require proof of income and charge several fees to make sure borrowers understand the risks before taking out an interest-free home loan
Both Naish and Markara agree if you have more than 50 per cent equity in your property and a repayment plan that's on track and accepted by lenders, then you should be okay with such loans. If you don't, you might find it difficult to remortgage when your existing deal comes to an end.
But what does it mean to have at least 50 per cent equity in their home? It means the homeowner should be ‘equity rich’, i.e. owe less than half their home's value on their mortgage. Being ‘equity rich’ helps because building home equity is a key way homeowners can grow wealth over time.
A key takeaway risk is the pressure of knowing that you have to ensure the loan is repaid in full at the end of the interest-only mortgage term. You'll usually pay more interest overall than with a repayment mortgage, because the amount you pay interest on doesn't decrease during the term.
But when you opt for a convention repayment home loan, not only will the amount you pay in interest decrease during the loan tenure, the debt repayment burden on your financial health will curb over time as well.