Ask Paul: Is interest-only better for my home loan?

Hi Paul,

I have seen suggestions that an interest-only loan is better than principal and interest on the basis that a home increases in value.

Would a good option be to put the difference into super for maximum benefit in the long term? - Norm

This is a really interesting question, Norm. It is relevant to so many people and, while it is a short question, it has a lot of personal complexity.

If a loan is on an investment property, it makes sense to pay interest only as the interest costs, maintenance and running costs of the property are tax deductible.

The key rule of debt repayment is straightforward. Pay the highest rate first, so that means high-interest credit cards, then things such as car loans, possibly your non-tax-deductible home loan and probably not the interest-only investment loans.

Now we'd better clear up 'possibly' and 'probably'. Let's assume your home loan is 6%.

Any principal repayments into your mortgage or a decent offset account effectively earn 6% tax and are risk free. Now this is a good return. If you were a typical taxpayer, you'd need a term deposit paying 10% to match that return after tax.

Bluntly, I also find that despite our best intentions to just pay interest and invest the balance, we actually spend the amount we would have paid into a principal and interest loan. This is not a technical answer, but it is a realistic human answer.

I reckon most of us are better off with a principal and interest loan. Also, your cheapest loan over time is likely to be a principal and interest loan.

Now to a deductible loan. Again, let's use 6% interest, though an investment loan is likely to be higher.

An average taxpayer would be paying about 4% after the deduction, a high taxpayer closer to 3%.

The point here is, can we earn more than the rate we are paying? At 3% or 4% we can.

We'd be better off applying any extra money to our home loan, our super or investments over the long term.

The history of shares, including dividends, shows an average annual return of close to 10%. Super, since the inception of compulsory super, has seen returns in the typical balance fund of 8% to 9%.

My view is to consider your personality and discipline to save and invest, the rate you are paying on a loan, the long-term earning rate on other investments, your attitude to risk and, of course, your personal rate of tax.

This will take you to a conclusion that is best for you.

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