In recent years, interest-only home loans accounted for around 40% of all outstanding Australian mortgages.
That was before regulatory bodies introduced measures to slow down this form of lending, and there’s now a cloud looming on Australia’s economic horizon in the form of $360 billion worth of these loans that are set to ‘expire’ over the next three years, upon which they’ll transition into the standard principal and interest repayment format.
There are some concerns that many of the borrowers of these loans will be unable to meet the significantly higher repayments that will kick in, possibly prompting a mass sell-off of property.
Source: Digital Finance Analytics, The Project
Given these concerns, it’s likely some borrowers don’t fully understand interest-only home loans and the risks they entail.
So if you’re considering an interest-only loan, read on to learn about what they are, the risks and benefits, what happens when they expire and how much more they can cost you over the life of your loan.
What is an interest-only loan?
Interest-only (IO) loans are home loans which delay the repayment of the borrowed amount (the ‘principal’) for a fixed term, usually between three and five years. During this time, you only have to pay the interest on your loan, not the principal. At the end of that set period, the repayments transition to paying off the principal as well as the interest.
An interest-only loan term is usually the same length as a standard home loan – around 30 years. However, instead of paying principal and interest for the full 30 years, you have the option to pay just interest for the first five years, for example, and then pay substantially more for the remaining 25 years. Interest-only home loans could be summed up as ‘less now’ but ‘more later’ in terms of the monthly repayments one has to make across the term of the loan.
Benefits and risks of interest-only loans
The decision to take out an interest-only loan should only be made after carefully considering the risks and benefits involved. Some of these are outlined below.
- Lower repayments: The temporary lower repayments of an interest-only loan can free up money for other expenses like renovations or paying off other outstanding debts.
- Investment Strategy: Interest-only loans are great for investors who plan to profit by selling their properties within the IO period (eg. after making a capital gain) because it reduces their expenses (and relative cash outflows)
- Buying time: The reduced repayments effectively let people buy time through the delaying of higher repayments. Whether it be a temporary reduction of income (eg. someone taking 2 years off to study) or a temporary increase in expenses (eg. 2 years of higher school fees), if borrowers are confident of returning back to a level of income or expense ‘normality’ at the end of the interest-only term, then interest-only loans are a great way for them to effectively buy time and flexibility.
- Pay more in interest: Since you’re not paying off the principal over the interest-only period, you’ll end up paying more interest over the life of your loan than someone who has been paying both principal and interest over the entirety of theirs.
- Higher interest rates (generally): Interest-only loans often have a higher rate of interest than principle & interest (P&I) loans. This isn’t the case for all lenders though.
- Repayment shock upon expiry: If you’re not prepared, the expiry of an interest-only period can come as a shock as the cost of repayments suddenly increase. The RBA reports that repayments could increase by around 30-40% as the principal is repaid as well as interest. For a typical interest only-borrower with a $400,000 30-year mortgage with a 5-year interest-only period, the RBA estimates this would equate to an extra $7,000 per year in repayments.
- Less equity: By only paying the interest portion of your repayments, you’re possibly (subject to property value movements) not building any equity in your property. Many investors in recent times have built equity through rises in the value of their properties, but if the value falls, you could end up owing more to the lender than what the property could actually sell for if indeed you were forced to sell the property.
How long can I take out an interest-only loan for?
Interest-only periods usually last between three and five years. Some lenders offer interest-only periods of up to 10 to 15 years, but this may be restricted to investors. You may be able to negotiate the length of the interest-only period with your lender, depending on your personal circumstances.
What happens when my interest-only loan expires?
When your interest-only loan period expires, your loan will roll over to principal and interest repayments. This means you’ll be paying off the outstanding mortgage as well as interest.
There are three main options you can pursue if your interest-only loan period is ending:
- Extend the interest-only period: Lenders will want to keep their customers and may be willing to extend your interest-only period. This will probably be subject to a credit assessment and property valuation.
- Refinance to another loan: If you’re nearing the end of your interest-only period, it might be a good idea to review your interest rate and finances before comparing other options in the market. Other lenders might be able to offer a better rate on a principal and interest loan than the rate of what your interest-only loan is rolling over to.
- Ride out the expiry: If you’ve planned well and you’re confident that you’ll afford the P&I repayments (and you’re happy with your interest rate), riding out the expiry of the interest-only period and transitioning to the P&I stage of your current home loan is the most hassle-free option at your disposal.
Interest Only vs Principal & Interest: Cost difference example
Desmond and Rachael have both found houses to buy and decided to take out separate loans of $400,000 for 30 years. Desmond chooses a P&I loan, while Rachael opts to pay interest-only for the first five years before switching to P&I for the remaining 25 years.
For the purposes of this comparison, it’s assumed both Desmond and Rachael have the same interest rate of 4.0% which holds steady over the 30 years.
|Loan||Monthly repayment during IO period||Monthly repayment after IO period||Total cost (principal & interest) of the loan|
|Total cost difference||$25,926|
As shown in the table above, by only paying interest for the first five years of the mortgage, Rachael’s loan will cost her $25,926 more than Desmond’s over the 30 years.
Interest-only home loans for owner-occupiers?
Interest-only loans can be a great short-term solution for property investors and owner-occupiers alike, however it’s important to remember that you will have to make principal repayments at some point down the track. Interest-only loans tend to have more benefits for property investors, while owner-occupiers (outside of what might be described as extraordinary circumstances) are generally better suited towards a standard principal and interest loan. Do your research and read the terms and conditions before making a purchase decision.
- Interest-only loans can offer great opportunities to build cumulative wealth from buying and selling property in rising markets.
- The flip-side to this opportunity is the risk that lies in getting caught when the market turns and profits do not materialise (or disappear).
- In this (unexpected) situation, interest-only loans can harm wealth through increased repayments after the interest-only period and/or having to sell the property at a net loss due to values falling and an inability to service new larger repayments.