DUBAI: Although they are not as common as traditional mortgages, interest-only home loans are often chosen when cash is tight when applying for a loan. But there are also risks. Let’s look at them in detail.
A ‘payback mortgage’ is a traditional home loan that involves making fixed monthly payments over the life of the loan. Payments consist of a portion of the amount allocated to paying interest (the cost of borrowing) and the remainder forming part of the amount borrowed (principal).
However, with an interest-only mortgage, you pay only a portion of the interest each month and are expected to pay the entire principal in full at the end of the term. So if you find it difficult to spend a lot of money each month to pay your dues at first, this type of loan is worth considering.
When you only pay the interest portion depends on the term of your mortgage and how much you borrow
– Rajesh Makala
How can an interest-only home loan work for you?
“The timing of paying the interest-only portion depends on the length of the mortgage and the amount borrowed,” said Rajesh Markara, a consumer credit analyst in Abu Dhabi. “After that, you will need to start paying off the principal that is due.
“In the past, borrowers may have sometimes managed to pay off the interest, but then the loan matured without being able to repay the principal. That’s why these loans are risky, and why they’re usually only five-year terms.”
Sometimes your lender will give you the option to pay off some of your principal during the initial interest-only period. Whether you choose to do this depends on how you intend to exit the loan, your financial situation and how useful this is to you from a planning perspective.
When Should You Consider Interest-Only Loans?
As mentioned earlier, since interest-only home loans are usually only allowed for short periods of time, the main reason to consider this is to reduce your monthly mortgage payments for a set time frame.
“While an interest-only mortgage is a good option when you have cash flow issues, lower monthly payments will also allow you more flexibility in spending while still meeting your mortgage commitments,” Dubai-based debt firm said adviser Rupesh Naish.
“An interest-only mortgage can also help if you have recently purchased a property and are looking for new tenants to rent out your property. An interest-only mortgage A loan can help you keep your investment to a minimum.”
Here is an example of when this type of loan can benefit
Over the course of a year, this would amount to approximately Dh40,000. In this case, opting for an interest-only mortgage for one year equates to a savings of Dh40,000. While this will benefit you in the first year, it won’t be as beneficial in the long run given the end-of-term costs of this type of loan. In addition to fees, interest-only mortgages typically require a much higher down payment.
What are the risks of an interest-only mortgage?
“Interest-only loans typically require a higher down payment, a higher credit score, and a lower debt-to-income ratio (DTI) than traditional loans. The amount of debt you can take on is proportional to your income, which is what lenders use to determine a measure of a borrower’s ability to repay a loan,” Markara added.
“While interest-only mortgages may be a good option for some borrowers, their high down payment requirements and end-of-term fees make them less of an attractive option. Additionally, qualifying may not be easy, Because you need to prove to the bank your ability to repay.”
Another risk with interest-only loans, Markara further explained, is that if your property loses value and you don’t make any principal repayments, you could end up owing more money than it’s worth, possibly requiring you to sell for a loss.
How else can you qualify for an interest-only mortgage?
So how can you qualify for an interest-only mortgage? In many cases, borrowers looking to opt for this type of loan typically need a credit score of around 680 or higher to qualify, which is above average.
“Lenders also require proof of income and charge several fees to ensure borrowers understand the risks before lending,” Naish added. In addition, because borrowers now have shorter loan terms, they must start making loan principal payments sooner than before. “
“Interest-only mortgages are better suited to borrowers with large cash reserves; borrowers who have had a significant recent increase in income; and those who are disciplined enough to shift their income-surge goal toward paying principal.”
Lenders also require proof of income and charge several fees to ensure borrowers understand the risks before taking out an interest-free home loan
Both Naish and Markara agree that if you have more than 50 per cent interest in the property and the repayment schedule is on schedule and accepted by the lender, then you should be able to take this type of loan. If you don’t, you may find it difficult to remortgage when your existing deal closes.
But what does it mean to own at least 50% of your home? That means homeowners should be “asset rich,” meaning they owe less than half their home’s value on their mortgage. “Equity rich” is helpful because building equity in a home is a key way homeowners can grow their wealth over time.
A key takeaway risk is the stress of knowing you have to make sure you pay off your loan in full at the end of the interest-only mortgage term. You will usually pay more in interest than you would repay on your mortgage because the amount of interest you pay does not decrease over the term.
But when you opt for regular repayment home loans, not only will the amount of interest you pay decrease over the life of the loan, your financially healthy debt repayment burden will also be curbed over time.