When you purchase a property, there are two types of mortgages you can select from: an interest-only mortgage or a principal and interest mortgage, which is also known as a repayment mortgage in some countries.
Interest-only mortgage or a principal and interest mortgage?
‘Principal’ is the amount you borrow from the lender. For example, I buy a $100,000 house with my $10,000 deposit and a $90,000 loan from the bank. The principal amount is $90,000.
‘Interest’ is the amount the lender charges you for the loan. Each lender sets different interest rates. For example, the bank might charge a 3.7% annual interest rate on the $90,000 loan, which has to be repaid weekly or monthly.
When you opt for a principal and interest mortgage (repayment mortgage), your repayments continuously reduces both the principal amount and the interest you owe. This means your overall mortgage debt decreases with each repayment.
When you opt for an interest-only mortgage, only the interest is repaid, but the principal amount remains the same. You are expected to pay off the principal amount, that is the $90,000 loan from the above example, in one lump sum when the mortgage ends.
Which type of mortgage is better for new buyers?
Though there are many pros and cons for each type of mortgage, I think it’s ‘safer’ to opt for a principal and interest mortgage when purchasing your first property.
That’s because, as a new investor, it’s better to be more risk-averse until you gain more experience and knowledge. Many investors may dispute this view.
When you finance your first property with a principal and interest mortgage, like I did, you know that your debt is decreasing. So you can be more confident that your loan will be paid off when your mortgage ends.
When you’re ready to invest in a second or third property, consider financing these additional investments using an interest-only mortgage.
The repayments for an interest-only mortgage is lower than a principal and interest mortgage, so you keep more of your cash in the bank. This is why my husband and I opted for an interest-only mortgage on our third and fourth properties.
Many people believe an interest-only mortgage is better because you have more than 20 years to save up the original debt you owe – in cash. Unless you’re very rich or are exceptional at saving money, this is wishful thinking.
Have you ever saved $200,000 in cash? If so, good on you! For many people, myself included, this won’t happen.
Also, you can’t predict what might happen later in your life that could limit your ability to save money, such as: having children; paying for education funds; bankruptcy; divorces; health issues; looking after an elderly parent; redundancies; etc.
Sell one property to pay off two mortgages
I believe the most effective way to pay a property financed with an interest-only mortgage is by owning two properties. When property number one doubles in value, sell this property and use the profit to pay the mortgage on property number two.
Alternatively, when interest rates decrease, switch from an interest-only mortgage to a principal and interest mortgage, to avoid paying the original debt you owe, in one lump sum, to the lender, when the mortgage ends.
This above is only one suggestion. Research how other investors have grown their property portfolio using an interest-only mortgage or a principal and interest mortgage. Then decide which type of mortgage works best for your financial situation.
So, do you prefer an interest-only mortgage or a principal and interest (repayment) mortgage?
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