Martin Hawes: Beware the holiday from hell

The term "mortgage holiday" is a misnomer.

A holiday is a break from something, a discontinuance of the things you normally have to do. However, that's not the case with a mortgage holiday - there's no time off, as the interest on your home loan keeps working away as hard as ever.

While you don't have to pay the interest during the mortgage holiday, it continues to accrue, is added to your loan balance, and then compounded.

This means the interest you don't pay is added to the principal and you then pay interest on the whole amount. In effect, you are paying interest on interest.

Albert Einstein called compound interest the eighth wonder of the world, because it seemed such a marvel the way an amount grows when compounded.

Compound interest is indeed a wonder for savers and investors - but it's a disaster for borrowers who take a payment holiday.

For example, if someone with a loan of $200,000 at 7 per cent takes a mortgage holiday for three months, at the end of this period the mortgage has grown to $203,400.

They will either have to increase the repayments or the loan term. Either option will be expensive in terms of the higher total interest paid.

Most lenders don't encourage borrowers to take a holiday and apply strict criteria: you probably won't get one for hardship reasons; you mustn't be in arrears and you'll need to have a fairly low loan-to-value ratio (certainly less than 80 per cent).

Most commonly, people who are able to take a holiday are those who have a temporary cut in income - for example, time off to have a baby.

At present you can usually only take one for three months, but it's being suggested that people should be able to take 12 months off from their repayments.

As a matter of public policy, doing anything to encourage people to take a break from their mortgage is a bad idea, especially if the holiday is to be for a longer period, such as 12 months.

A mortgage holiday is to be avoided - it really is the holiday from hell. Look for every alternative you can: go to an interest-only loan for a while or try to increase your income.

* Each week financial author Martin Hawes shares strategies to help you grow your wealth. You can email finance questions to info@wealthcoaches.net or andrea.milner@heraldonsunday.co.nz

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