Should You Get An Interest Only Loan?
Interest only loans popular in 2017
In 2017, interest only lending peaked at 40 per cent of new mortgages issued by banks. According to a leading economist, Professor Richard Holden, this could potentially result in mass defaults as the interest only terms on these loans end and borrowers have to meet higher repayments.
In 2017 the average interest only mortgage is worth $347,000*, with 1 in 4 owner-occupier loans and 2 in 3 investment loans were interest only**.
Banking regulator APRA concerned
In March of 2017, anticipating future problems like the 2008 US subprime meltdown, the Australian Prudential Regulation Authority (APRA) ordered banks to reduce the volume of interest only lending to below 30 per cent of new loans.
Since then, banks conduct has been brought under closer scrutiny during the much-publicised ASIC banking enquiry, and responsible lending practices are being closely monitored.
What if I have an interest only loan?
For Australians with a current interest-only loan, when it resets to principal and interest, the typical borrower will face an increase in their mortgage payments of around $7,000 per year, according to the Reserve Bank of Australia assistant governor Christopher Kent.
Around $120 billion of interest only loans are scheduled to roll over to principal and interest over the next three years, so if you have an investment loan in an interest-only period, you need to consider your options now.
What do Australians think about interest-only lending?
Recent research from Gateway Credit Union that surveyed 1,000 borrowers over 18 years found that 46 per cent of Australian's wouldn't choose an interest only home loan, despite recognising that these loans do have benefits.
Only 18 per cent of those surveyed were enthusiastic users of interest only home loans, who appreciated the benefit of increased cash flow.
An interest-only period has a set time, usually around five years, after which the mortgage holder has to pay both principal and interest. This can come back to sting a borrower if they haven't planned ahead.
Interest only vs principal and interest.
While interest-only loans are getting a lot of heat from the regulators, they do have their place for investors who manage their finances wisely as a tool for maximising future gains.
The regulator scrutiny of interest only loans has resulted in higher interest rates on interest only loans.
Interest only loans vs interest and principal loans
|Lower repayments at the start of the loan||Higher repayments when the interest-only period ends (around 30-40% more)|
|Greater tax deductions for investment properties||More expensive over the life of the loan|
|Can be used for bridging or construction loan||Principle doesn't reduce|
|Use of offset account can reduce interest charged on the principal.||Interest rate can be higher than interest and principal loans.|
If you're considering taking out an interest-only loan, you'll need to consider whether the short-term benefits will outweigh the long-term costs.
When to choose interest only
Choosing interest only loans with an offset facility can allow you to reduce your monthly mortgage payments.
1. Using an offset account
You can minimise you non-deductible debt to secure a capital gain on your property with an effective tax strategy. For this to work in your favour, you'll need to be disciplined about paying extra amounts each month into your offset account to reduce the amount of interest that you'll pay on the principal.
Money in your offset account counts towards your loan principal. If your total mortgage principal is $400,000 and you have $25,000 in your offset account, you'll pay interest on $375,000.
The money in the offset account is still available if you have an unexpected change in circumstances, though accessing it outside an emergency is not recommended.
2. Turning your home into an investment
When you buy your first home, it's often not the place you plan to live long-term. If you intend to turn your first home into an investment in the future, an interest-only loan can help you to build a cash buffer for your next home purchase, while effectively managing tax costs through an offset account.
You could benefit from greater tax deductions on the existing debt if you haven't fully repaid your mortgage before your next home purchase.
To be eligible for an interest-only loan, you will need to demonstrate that you can meet the payments of principal and interest, based on your current income, not just the interest-only payments.
When to choose interest and principal loans
Interest and principal loans are a better option if you find it hard to save because it forces you to make payments toward the principal amount each month. In most cases, you'll also get a lower interest rate.
Paying both principal and interest payments right from the start of the loan could potentially save you a lot of money over the life of your loan.
This case study from ASIC illustrates the benefits of forced savings over the life of your loan.
In each example, the borrower borrows $750,000 over 30 years.
|Principal & Interest||Interest-only 5 years||Interest-only 5 years|
|Monthly payment (interest only period)||$3,559||$2,469||$2,656|
|Monthly payment (principle & interest)||$3,559||$3,938||$4,063|
|Additional interest due to interest only period||$0||$48,304||$97,035|
You can see in this example that without strategic use of an offset account, your mortgage cost will be significantly higher with an interest-only loan.
Interest and principal loans are a lower risk option that many Australians choose to ensure that their balance sheet remains healthy, and there's no repayment shock at the end of the interest-only term.
Seek the right mortgage advice
When planning your next mortgage, it's important to seek the advice of your accountant, as well as an experienced mortgage broker.
Discuss your future goals and intentions with them to form a cost-effective plan for your future property purchases.
If you need mortgage advice, the Positive Home Loans Team are willing to listen to your plans and offer their expertise, no matter where you are in the buying process so you can make informed decisions about your future.
*APRA, Quarterly authorised deposit-taking institution property exposures, September 2017.
**ASIC survey of 11 lenders, 2015.