Interest-only home loans: The pros and cons

Interest-only home loans: The pros and cons

14 Sep, 2020

With a coronavirus-led recession now very much a reality across the country, many Australians face stressful financial times.

And with their home loan representing the biggest financial commitment most Aussies have, it’s a logical place to look for potential savings when circumstances shift.

Making changes to your mortgage is one way to fine-tune a budget and it’s an approach many are already taking up.

The Australian Prudential Regulation Authority (APRA) reported in July that as of the end of May, 11% of housing loans had been deferred, ie put on hold entirely, representing $192 billion out of a total of $1.7 trillion in home loans. And this came after 9% of home loans had been deferred as of the end of April.

Another option many people are investigating and taking up is “going interest-only” on their home loan for a period of time, as a way of reducing their expenses, while navigating these challenging waters.

Initially capped by APRA in an effort to cool an overheating real estate market in 2017, regulations governing interest-only loans were lifted in 2018.

While an option worth considering, there are implications for borrowers over the full life of a loan. Let’s take a look at what this type of loan involves and its pros and cons.

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What is interest-only?

Loans generally consist of two parts: the principal and the interest. The principal is the money you have borrowed to cover your purchase, while the interest is what the lender charges you for providing the loan.

Interest is generally calculated on what you have remaining in unpaid principal. Loan repayments will in most cases cover this interest for the period of the repayment as well as pay back a portion of the principal.

These are the principal and interest loans. However, an interest-only loan only requires you to pay back the interest owed, it does not reduce the principal.

What is an interest-only repayment type?

An interest-only home loan is a way you can delay paying back the principal of your mortgage for a set period. This means you only pat the interest on your loan during the period, which is usually between three and five years.

Banks and financial institutions have interest-only loan products you can discuss with them, either at the start of the loan or for another portion of the life of the loan, but keep in mind that generally there is an expectation your loan will be a principal and interest type for the majority of its life.

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What are the benefits and risks of interest-only mortgages?

As with any financial decision, there are risks and benefits to interest-only loans and they may not suit everyone’s situation. Here are some things to weigh up.

The risks

Over the life of your loan, you will end up paying more in interest by delaying principal payments for a period. Because interest is calculated on the principal owed, your interest payments will not decrease as they would if you were also paying back the principal. So while you pay less now, you’ll pay more later.

After your interest-only period expires, you will have higher repayments, and they will be higher than at the same stage of a principal and interest loan. This is because you will still be expected to pay back the principal and interest within the time initially set for the loan.

Banks will generally charge you a higher interest rate if you include an interest-only period in your loan, although this is not the case for every lender. These rates and conditions vary across institutions, so make sure you shop around.

Because you have not reduced the principal owed during the interest-only period, you will have lower equity than if you had.
Equity is the difference between what the market will pay for your property and what is owed on the mortgage. Generally, the more you have paid off, the more equity you have, assuming property values do not drop dramatically.

Because you have not reduced the principal owed during the interest-only period, you will have lower equity than if you had.

Equity is the difference between what the market will pay for your property and what is owed on the mortgage. Generally, the more you have paid off, the more equity you have, assuming property values do not drop dramatically.

In a worst-case scenario, if property values fall and you are forced to sell before you have paid off a certain portion of the principal, you could be left still owing to your lender after the sale.

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The benefits

Interest-only loans are a way to build flexibility into your mortgage if you need to delay making full repayments for a period, say during a financial tough time, to study or to get some other spending out of the way first. If you know you can make the full repayments later, they can be a useful option.

These loans also offer some advantages for investors. If a property can gain value and be sold during the interest-only period, the loans can significantly reduce investors’ expenses and improve cashflow.

While you are not paying off part of the principal, the extra capital available could be used for such further investment as another property, refurbishment of your current properties, or even help pay off a mortgage on your current residence faster. The interest-only period will give you the option of utilising more through reduced repayments.

Another thing to consider is a lower tax burden. Payments towards interest on a loan are tax-deductible, while payments reducing the principal are not. The interest payments can be offset against other income, while the loan structure frees up capital that could have gone towards principal payments. 

How long can you take out an interest-only mortgage for?

Most lenders in Australia will offer interest-only periods for anywhere from three to five years. However, longer periods are possible for investment loans, possibly even up to 15 years, but may not be available on all loans. 

What happens when an interest-only period expires?

Once your interest-only period expires, your loan will transition into a traditional principal and interest loan. Your loan repayments will be adjusted so you start to pay off portions of the principal along with the interest calculated on the remaining debt.

How does the interest-only option affect your home loan repayments?

Once the interest-only period expires, your repayments will increase to cover paying off the principal and the interest. Because you have not reduced the principal during this period, the interest will be higher because the principal you have to repay is higher than if you had paid part of it off as part of a principal and interest loan. You also have less time to pay it off in.

For example, say you borrowed $500,000 at 3.5% interest over 25 years, making monthly payments. If your repayment type is principal and interest, your monthly repayments will be $2503. At the end of the 25 years, this mortgage will have cost you $750,935 in total.

Choosing a five-year interest-only period at the beginning of the loan reduces these monthly repayments to $1458 for the first five years, then after this they will increase $1442 to $2900 per month for the remainder of the loan.

The overall cost of this loan is $783,452, an extra $32,512 over the life of the loan compared with the principal and interest loan.

What are your alternative options?

As well as going interest-only, there are other alternatives to look at during tough times. They vary from lender to lender and very much depend on your personal circumstances.

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Switch your repayment type

Now might be a good time to discuss with your lender if your loan type is best suited to you. It could be better for your situation to change type, say from fixed interest to a variable rate.

Extend the interest-only period

Your lending institution may be willing to extend your interest-only period. Discuss with your lender what the implications are for the life of your loan, including the level of your repayments in the future and what the forecast is for the value of your property. They may also wish to assess your financial situation before making a decision.

Discuss with a home loan consultant what other options you have

Exploring the option of refinancing your loan is another option. A home loan consultant may suggest researching the market to see if you could get more competitive rates for your principal and interest loan.

You could also ask your current lender if they could give you a more competitive rate. And if you think you will have difficulties meeting the increased payments, approach your lender to let them know your situation and see if you can change the terms of your loan to make it easier.

In some cases, they may be able to temporarily pause or reduce your repayments. Generally, lenders are keen to retain their customers, so discussing this circumstance and options may be more straightforward than you think.

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Words by: Erin Delahunty

Sources:

Australian recession confirmed as COVID-19 triggers biggest economic plunge on record

Temporary loan repayment deferrals due to COVID-19 – accessible version

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