Most home loans are based on principal and interest. That is, you pay off the principal amount (the amount you have borrowed) in addition to the accumulated interest. However, when servicing an interest only loan you will only pay off the interest component for a period of time, thus greatly reducing your monthly obligations.
While an attractive option – particularly for investors – there are potential risks associated with the product. However, the also serve a very practical purpose with construction loans (by paying interest only during the construction stage), and on bridging loans. In both of the latter cases the interest-only component applies for a defined portion of the loan.
The maximum interest-only loan period is typically five years for owner occupiers, but may be longer for investment loans. After this period, the loan reverts to principal and interest repayments.
Example Interest Only Products
Following is an example of some of the Interest Only loans on our panel. Keep in mind that you should consult with us so we’re able to properly guide you into a suitable product and schedule. Note that we’re showing the Owner Occupied Interest Only rates (various Investment products will differ). The product panels may appear similar, with the product page showing the various options for each product – including the Fixed and Variable options. Each page includes the LVR qualifying criteria.
We have dozens of interest only products that may be suited to your circumstances.
Interest Only Benefits
Some of the advantages of an interest only loan include the following.
Lower Repayments for a Short Period
While you’re paying an interest only component your monthly obligations are lower for that period of time, before the loan reverts to a principal and interest payment schedule.
There are times when you’re experiencing hardship that switching to an interest only loan might make your obligations more manageable, and we help you negotiate with banks to make this transition. However, if you find yourself in a position of hardship we’d prefer to talk to you straight away so we can assist you with various types of hardship options.
Make Cash Available for Other Purposes
There are times, however infrequent, where having lower monthly loan obligations makes more cash available for other purposes. For example, a first home buyer might opt for this schedule to make more money available for emergency funds, or for renovations and furnishings. As we’ll come to describe, the loan is usually more suitable for investors where a smaller repayment is offset by the expected capital growth.
Permit Lower Entry to the Investment Market
Investors will often gravitate towards the interest-only loan because of the lower repayments, with the gain offset by the capital growth of your asset, although this is a calculated risk you’ll want to take with the guidance of a property expert. Additionally, the lower repayments with the higher debt means you may benefit from tax deductions, although, once again, you’ll want to consult with a suitably qualified financial planner.
Interest Only Disadvantages
Interest only products certain’t aren’t without their disadvantages. A few are introduced here.
Your Repayment Obligations Will Increase
Once your loan reverts to a principal and interest loan your interest-only obligations will increase at the rate assigned to your product which is generally higher than a Principal and Interest loan. These additional repayments include the full principal amount since you haven’t paid off any of this balance until now. In summary, it’s worth noting the following:
- Interest-only rates are higher than Principal and Interest Loans.
- You are paying interest on the full balance of the loan at the higher rate.
- When the loan reverts to the Principal and Only loan your repayments will include the full Principal, making your repayments higher (at a higher rate).
By utilising a principal and interest loan the principal would decrease over time, as would the amount of interest being charged… assuming the interest rate does not increase. Negative Equity occurs when the property value decreases during the period of Interest Only obligations, and it may impact on your capacity to invest in additional property.
Less Equity in Your Property
During the interest-only period you are not increasing your equity in the property. In other words, you are not paying off any of the property’s value. Investors generally rely on the value of the property increasing during this period, and usually at an amount greater than the interest obligations.
First Home Buyers generally have little equity in their home when they first move in, usually less than 20% and far lower if utilising First Home Grants. This makes it more difficult to refinance into a lower rate later on, or possibly enter the investment market (that 20% equity in your home is great starting point for first time investors).
When the Interest Only Period Ends
A few options apply at the end of your Interest Only period. You may revert to the Principal and Interest repayments as scheduled by your mortgage product (at the higher rate that continues to apply), you may negotiate an extension on the Interest Only period, or you may choose to refinance into another product.
If your Interest Only loan permits additional repayments it’s often a good idea to make these payments when available, although in consultation with your financial planner he or she may advise against this in favour of the higher debt. In recent history many borrowers that gravitated towards an Interest Only loan suffered hardship when the product reverted back to the Principal and Interest obligation.
As an investor, in particular, it’s difficult to make interest only decisions without knowing the numbers, and without professional guidance. Thankfully, we have professionals and partners on hand to guide you through this minefield.
Are Interest Only Loans High Risk?
In March 2015, Aussie Home Loans chairman “Aussie John” Symond called for a ban on interest-only loans for home owners, saying that “… there is a general consensus that interest-only loans need to be pulled back”. He went on to say that “owner occupiers – normal mums and dads taking home loans – I would ban interest-only loans to them. If you can’t afford to pay interest and principle, then you shouldn’t get a loan”. Then in March 2016, APRA chairman Wayne Byres said the higher proportion of interest-only lending was indicative of a “higher-risk profile” it would be monitoring.
Fast forward a few years and many Interest Only borrowers did indeed find themselves experiencing some measure of financial hardship – nearly 50%, in fact.
The risk, of course, is that the property won’t increase in value for investors, so they’ll find themselves in further debt at a time when additional monthly obligations are required of them. Some banks now have more strict criteria for the Interest Only loan, with some offering them during the Coronavirus Pandemic to ease the financial burden on households. Some banks have a higher LVR, and others have other qualifying criteria.
Used correctly, and with the appropriate guidance and professional support, Interest Only loans certainly have their place, but the risks certainly need to be understood.