Interest only trend great for banks, terrible for borrowers

Not all innovation in banking products is designed to help customers and the current emerging trend to offer 10-year interest free loans on owner occupied properties is a classic example.

While the sales pitch on these products is that they are ideal for pre-retirees so that they can still afford repayments once they are retired, in reality it is the bank that is truly benefiting from these loans.

While it is true that there can be initial cash flow benefits from an interest-only loan, in the longer term the borrower is paying up big time for this convenience.

Higher rates penalise borrowers

The first reason why these loans are more expensive is that they have higher interest rates which can really add up in a short space of time.

Canstar analysis of Reserve Bank figures found that rates on interest only mortgages are on average 0.93% higher than for conventional owner-occupied home loans.

That leaves an immediate dent in both the affordability and cash flow of these loans compared to conventional principal and interest home loans.

Principal amount stays the same

The second big disadvantage of these loans is that no outstanding debt is being repaid, so the interest bill continues for many years longer than would otherwise have been the case.

When you take both of these factors into consideration and crunch the numbers for pre-retirees that take advantage of these sorts of loans, they are likely to be costing themselves much more money than they’re saving.

Paying off home loans in retirement becoming common

What the emergence of these products does suggest is that banks are now expecting many more people to be repaying home loans well into their retirement years and see this as a market worth chasing.

Indeed about 90% of super savers above the age of 50 believe they will still be paying off a home loan well into retirement.

Once again this makes this new class of loan another example of a financial product that offers short-term convenience with a very large long-term cost.

When you consider that average superannuation returns exceed the amount of interest on home loans, the true cost of this convenience becomes even clearer.

A few alternative strategies to consider

One potential strategy that many retirees ignore is to realise that the minimum pension payments that apply to superannuation payments are exactly that – a minimum.

If a retiree with a mortgage is struggling to raise enough cash flow from their super to meet their living costs and the mortgage, an obvious strategy is to draw down some extra from the superannuation fund compared to the minimum.

In the early years of retirement this may mean withdrawing a full 5% annual payout instead of the mandated 4% which applies up until the age of 65.

While this will have the effect of reducing the superannuation account a little over time, if the extra is being used to repay a principal and interest home loan, the long-term advantage will become obvious once the loan term ends and extra cash flow is released to meet living costs.

Not only is a home loan still being paid off progressively, the maximum possible amount is still being left in the superannuation fund to earn returns that on average are higher than those applying to the loan.

A variation of this strategy would be to make extra principal payments off while still working.

Even small reductions of principal make a big difference because interest costs are no longer being accrued for years on that amount.

Lump sum and offset account?

Another strategy could be to draw down lump sum payments to reduce the home loan balance or to instead leave this amount in an offset account to reduce the interest on the loan if access to the money may be required.

When considering 10-year interest only loans or any other financial product, it is always best to search for the most economical, fast and efficient way of achieving your end goal.

There may be some people for whom a 10-year interest only home loan is the best answer to the problem of paying a home loan well into retirement but it is vitally important to make an informed decision and not just accept the costly “convenience” of a cleverly marketed financial product.