Interest only loans have been a popular choice for property investors for tax purposes, and first home buyers and other borrowers looking to minimise the repayments on their debt. Many purchasers use Interest only loans to ease the financial burden of servicing their loan.
Due to the growth of the property market in recent years, the average loan size has increased, and Interest only loans can be a short-term option to reduce the repayments and improve affordability. This type of loan is a popular choice for property investors to lower the repayments, while hopefully the value of the property increases in value over the longer term. Many lenders offer Interest only options on their products for up to 5 years.
On a loan of $300,000, the monthly repayment on an interest loan would be approximately $500 less per month than an equivalent Principal and Interest product at the same rate. There can be significant savings on repayments for an Interest only loan in the shorter term, but there are also some longer-term issues:
- As the name suggests, you are only paying back the interest on the debt. You are not making any progress on your mortgage! At the end of the Interest only term based on the example above, you still owe $300,000. If you selected a Principal and Interest loan (at the same rate), you would have reduced your loan by nearly $30,000.
- Property investors and homeowners expect that the property will increase in value over time. With an Interest only loan, you will have equity in the property without paying any principal. However, if your property doesn’t substantially increase in value over the Interest only term, you will not have gained any equity in the property.
- At the end of the Interest only period, the loan repayments will ‘rollover’ to an increased Principal and Interest repayment. Many borrowers may be unprepared for the additional financial commitment, and will experience ‘Mortgage Stress’. If the borrower’s circumstances have changed since the loan was established, and they cannot extend the Interest only period, it may be difficult to refinance to another Interest only loan. The only option may be to sell the property.
As of 2015, Interest only home loans represented approximately 40% of the residential loans in Australia. From March 2017, the lending regulator, Australian Prudential Regulation Authority (APRA) introduced restrictions on new Interest only loan business. APRA has limited Interest only lending to less than 30% of new loans written. The restrictions were imposed In order to limit riskier forms of lending practices, which allow borrowers to pay for escalating property prices, while not reducing their debt.
The restrictions introduced by APRA have led to rate increases on Interest only loans, and tougher requirements for customers applying for Interest only loans. Interest only loan applicants may be subject to increased scrutiny such as more thorough income verification and higher loan servicing standards.
There have been several headlines recently in relation to the issues with Interest only home loans ‘rolling over’ to Principal and Interest loans after the interest-only period expires. The Reserve Bank of Australia has estimated that over the next 3 years, approximately $360 billion of Interest only loans will convert to Principal and Interest Loans. This will increase the repayments by approximately 1/3 or $7,000 p.a. on average for a $400,000 loan.
The rollover to Principal and Interest repayments may leave many borrowers struggling to meet higher repayments. The most vulnerable will be homeowners with a high Loan to Valuation Ratio (LVR) who will find it harder to refinance or sell the property to extinguish the debt.
If you need assistance with your home loan or lending needs, please contact one of our lending specialists to determine the costs and benefits, and to discuss your options.
Please note that the above has been provided as general advice. It has not taken into account your personal or financial circumstances. If you would like more tailored advice, please contact us today, one of our friendly advisers would love to speak with you.