Q I am considering swapping to an interest only loan on my principle place of residence. Would I save more interest and pay the loan off quicker by staying with a principle and interest loan and making fortnightly payments? Alternatively would I be better using an offset account for my savings and pay interest only? Which will equate to a more rapid mortgage reduction?
A The definitive answer to your question is whichever mechanism enables you to pay down the debt the quickest is the most appropriate structure. The most appropriate loan structure and repayment method will depend on your income, your cash flow needs and how disciplined you can be around money and debt reduction.
Principle and interest (P and I) loans work best for those who want the certainty of knowing the loan will be paid off on or before a pre-determined date. Borrowers often motivated by seeing the loan balance diminish on a monthly basis. They may want or require the forced discipline of regular principle payments. P and I loans are typically offered by lending institutions for between 1 and 30 years. Obviously the difference in loan term duration will determine the size of the contracted monthly payment and the ultimate amount of interest you pay.
Interest Only (IO) loans work best for those who want the lowest minimum monthly repayment on a mortgage or do not wish to focus on paying the debt down immediately. Borrowers may require greater flexibility as to how and when they reduce the debt. Whilst the loan term may be up to 30 years, typically the loans revert to P and I after say 5 years IO. Typically they suit those who have an investment property or who wish the minimum obligatory payment to be as low as possible.
Fortnightly loan repayments are an effective means of paying back a debt quicker. There is no great mystery to why; a fortnightly loan repayment is set at half the monthly loan payment obligation, however there are 26 fortnights in a year so you make an extra monthly loan repayment a year.
As the name suggests, an Offset account offsets the balance of the account against the outstanding loan balance. Mortgage interest is typically calculated on a daily balance so the more you have in the offset account and the longer you retain it in the account, the greater the interest offset.
Whether you pay more off the actual loan or leave more in an offset account, they have the same effect on the interest charged. The consideration may be more around the flexibility you may need with your loan facility; will you be able to redraw funds in the future for example to renovate or to supplement income if you are off work for a period of time. From a tax perspective, are you better redrawing from an offset account or directly from the loan?
In deciding whether to have a P and I or IO loan, consider the purpose of the loan; is it for investment or home purchase? Consider how long you wish to have the loan facility; is this for a shorter term or long term need? Consider your cash flow requirements; can you afford higher minimum payments associated with a shorter term loan or do you require the comfort of a lower minimum payment in the event of a change in circumstance?