The good and bad of interest-only repayment periods.
Interest-only lending might be dwindling yet it's still a popular option for many home loan borrowers. However, this repayment structure has its own benefits and drawbacks as we explain here.
Interest-only repayments can be a good strategy if you manage them correctly. There are a number of benefits you can see by choosing this option.
Lower your repayments
Choosing an interest-only option can significantly lower your monthly repayments. For example, if you had a $500,000 home loan at 4.00% interest, your monthly principal and interest repayments would be $2,387. However, if you switched to interest-only repayments your monthly repayments would fall to $1,667. That's a $720 difference.
If you're a first home buyer, choosing an interest-only option for a period of time can ease you into the habit of making regular home loan repayments. By the time your interest-only period ends, you will have better adjusted to the discipline of meeting your repayments.
Invest in other asset classes
Interest-only repayments can free up cash you can use to invest in higher-growth assets. If you can find an investment that offers a better rate of return than the interest rate on your home loan, it could make sense to divert your funds there rather than to principal and interest repayments.
The caveat to this benefit is that you have to be disciplined enough to actually invest the funds you free up. Moreover, you need to be reasonably confident that your investment will have a higher yield than the interest rate on your home loan.
Maximise tax deductible debt
If you're a property investor, interest-only home loan repayments can be a very savvy investment strategy since interest repayments are tax deductible for investors. If you choose an interest-only option, you'll be able to deduct your entire home loan repayment.
Opting for an interest-only home loan also helps to maximise your cash flow as a property investor. By keeping your repayments low, you minimise the expenses associated with maintaining your investment property and increase your rental yield.
Interest-only loans also come with their own unique drawbacks and risks. You'll need to carefully weigh these risks before deciding on an interest-only option.
Repayments will jump after term ends
Interest-only repayments are a finite arrangement, with periods generally lasting from one to five years. At the end of this term, your home loan will automatically revert to principal and interest repayments. Once this happens, you will see a sharp and sudden increase in your monthly repayments.
For instance, if you have a 30-year, $500,000 interest-only home loan at 4.00%, you will have gotten used to making repayments of $1,667 per month. If this period lasts five years, your loan will revert to principal and interest and you'll still owe $500,000, but this time on a 25-year term. Your repayments would jump from $1,667 to $2,639. Suddenly being forced to come up with nearly $1,000 extra per month could be difficult to accommodate.
You may take the option to refinance your home loan to a new 30-year term. In this case, your home loan repayments would still jump from $1,667 to $2,387. Moreover, your new 30-year term would extend the amount of time it takes to pay off your home loan, as well as the amount of interest you pay.
Increases amount of interest you pay
Choosing an interest-only repayment option will increase the total amount of interest you pay over the life of your home loan. Since you won't be reducing the principal during the interest only period, when you do begin principal and interest repayments a large portion of your regular repayment are devoted to interest repayments as interest is still being calculated on the original loan amount.
For example, if you have a 30-year principal and interest home loan at 4.00%, you'll pay a total of $359,348 in interest over the term of the loan. By contrast, if you have the same loan but start with a 5-year interest-only period, you'll pay a total of $391,755 in interest.
The difference becomes even more marked if you choose to refinance to a new 30-year term at the end of your interest-only period. If you choose to do this, you'll pay a massive $459,348 in interest over the course of your home loan.
Difficult to qualify for
Interest-only home loans used to be an attractive option for both lenders and borrowers. Borrowers got lower repayments for a period of time, while lenders made a higher return through increased interest payments.
However, Australia's banking regulator, the Australian Prudential Regulation Authority (APRA), has cracked down on interest-only lending. The regulator announced last year it would expect lenders to limit interest-only loans to 30% of new lending, and to severely limit lending above 80% loan-to-value ratio (LVR) for interest-only loans.
As a result, lenders have wound back interest-only lending. Investors can face a difficult task being approved for an interest-only home loan, while very few owner-occupiers can expect to be approved.
If you're an investor, you can still get approved for an interest-only home loan. However, you may have to provide a detailed strategy outlining why an interest-only home loan is the most suitable option for you. Except in very rare cases, you're unlikely to be approved for an interest-only home loan as an owner-occupier.
Home could decrease in value
After a long period of dramatic house price increases, it's easy to assume that Australian property values will rise perpetually. Unfortunately, this is unlikely to be the case.
If Aussie house prices fall significantly, interest-only borrowers could find themselves in a difficult position. During your interest-only period, you won't be reducing the principal of your home loan. This means you won't build equity in your home by making repayments. This is fine if home values rise, as you'll still end your interest-only period with equity.
However, if home values fall you could find yourself in negative equity. This is a situation in which you owe more than your house is worth. This can be a dangerous position to be in, as you wouldn't be able to repay your home loan by selling your house.
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