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Refinancing an interest only home loan
Refinancing an interest only home loan works the same as any other loan, but if you don't own 20% of your property, it can get expensive to switch.
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You can refinance your interest only home loan if you want. You can switch to a loan with principal and interest repayments, or you can refinance to a new interest only loan. Whatever you want to do, refinancing is easier when you have some equity in your home. This is where some borrowers might have a problem.
I want to refinance my interest only home loan
Refinancing just means switching from one loan to a new one. You can refinance with the same lender or to a completely new lender. Home loan refinancing works the same whether your loan is an interest only home loan or a principal and interest loan. To refinance, you simply:
- Look for a new loan and see how it compares to your current loan (look at the rate, fees and features).
- Apply with the new lender and get your paperwork together.
- Once your loan is approved, you discharge the old mortgage and the new one begins.
The challenge for interest only borrowers is that you might not have much equity.
It's hard to refinance if you don't own 20% of your property's value
Equity means the value of your property, minus any remaining home loan debt. If you bought a $600,000 home with a $100,000 deposit, and have repaid a further $50,000 off the loan principal, you'd now have $150,000 in equity and $450,000 in debt remaining. But if your property has grown in value (let's say to $640,000) then you'd have an extra $40,000 there.
- $640,000 (current property value) minus $450,000 (remaining debt) = $190,000 equity
But you only build equity by paying off the loan principal. That's the money you've borrowed. If you have an interest only loan, you are not repaying any principal – you're just repaying the interest on top.
And this is why interest only refinancing can get expensive. If you want to borrow more than 80% of your property's value (meaning your deposit is smaller than 20%), a lender will charge you a lender's mortgage insurance (LMI) premium. This can cost you thousands of dollars.
If you got an interest only loan with a 10% deposit, then you probably paid LMI on your first loan. But if you refinanced, your new lender would charge you LMI again.
Rising property prices can make interest only refinancing easier
The only way to avoid this is by repaying some of the loan so that you reach 20% equity, or hope that property values have risen a lot.
Here's a quick example:
- You bought a $500,000 home with a 10% deposit ($50,000) 3 years ago.
- Your loan has a 3-year interest only period, so you still owe $450,000.
- But your home is now worth $570,000.
- This means you now own just over 20% of the property's value and can refinance without paying LMI.
Can I refinance from a principal and interest loan to an interest only loan?
You can switch to an interest only loan. But you need to make sure you understand why you're doing this. Interest only loans are suited to the specific needs of a certain few borrowers (and mainly property investors). Due to this, there are only a few situations when it's beneficial to refinance an interest only loan.
Reducing your repayments in the short term
Switching from principal and interest to interest only payments will drastically reduce your loan repayments – for now. This is because you only have to pay the interest charged on top of the loan. But over time, you will end up paying a lot more because you're paying more interest and delaying the repayment of the money you've borrowed.
Borrowers who are struggling to make repayments may find some relief in refinancing to interest only payments. But it's important to understand that in the long term, it's costing you more.
Also, you could try asking your current lender to switch your loan to interest only payments. This can be easier than refinancing.
To take advantage of investor tax benefits
Interest only loans are popular with property investors, partly because of tax benefits. As an investor, you can deduct the interest paid on your investment loan from your tax bill. However, this is something you can't do as an owner occupier.
Some investors also try to hold an investment property for only a few years while hoping for large capital gains. This can work if you buy the right property in a booming market (although it's a risky strategy). In this case, refinancing to an interest only loan makes sense because it's cheaper. You're not worried about repaying the loan because you're planning to sell the property in a short period of time.
I want to switch from interest only to a principal and interest loan
This is a more common scenario and has a number of benefits. With a principal and interest loan you can:
- Pay off your debt and build equity. Once you start paying off the loan principal, you own more of the property. You're building equity and wealth for the future.
- Access lower rates and more mortgage features. Interest only loans usually have higher interest rates and fewer mortgage features, such as offset accounts. This means you can get a more competitive loan with useful features.
But there are a couple of things to watch out for when leaving an interest only loan:
- Your repayments will increase. Principal and interest repayments are much higher than interest only repayments. Be prepared for this increase in costs by looking at a loan repayment calculator, assessing your income and spending, and doing a budget.
- You might not have much equity. As we covered above, if you've only been making interest only repayments then you haven't built equity. This makes it harder to refinance. If you started with a 20% deposit and your property hasn't lost value, you should be safe. But if you started with a small deposit and haven't repaid any mortgage principal, you may need to pay LMI again.
Still confused about interest only refinancing? Speak to a mortgage broker
Mortgage brokers can help you find a new loan when you're in a complicated situation, and this includes interest only refinancing. They can advise you on the right course of action and help you avoid making a costly mortgage mistake.
Interest only home loan comparison
We update our data regularly, but information can change between updates. Confirm details with the provider you're interested in before making a decision.
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