Interest only loans…are they right for you?

Up until recently, the large majority of investment property owners would have been paying interest only repayments on their investment loan.  Why?  In most cases, it was probably to maximise the tax benefit associated with the interest deduction.  Another benefit is the reduced strain on cashflow.  The lower monthly repayments can free up cashflow for other uses, such as paying off other non-deductible or higher interest debts

However, there have been some recent changes made by the financial services regulators (ASIC and APRA) which has caused lenders to make policy changes with respect to interest only loans.  As a result, interest only loans are significantly more expensive than their principal and interest counterparts.  In addition, lenders are restricting the renewal of interest only terms.  If you have already had a five-year interest only term, the lender may consider renewing for a further five years but will not go beyond ten years.  Therefore, if you have an interest only loan that is coming up to its 10-year anniversary, it is unlikely you will be able to renew with that lender.

There is always the option of refinancing with another lender in order to maintain your interest only repayments but consider this…the Perth property market has struggled in recent years and if you have been making interest only repayments, then the principal of your loan will remain the same.  If the value of your property has not increased due to the slow market, or worse yet, decreased, you may not be able to refinance.  In most cases, lenders are refusing to allow interest only terms where the loan to value ratio is above 80%.

Things to consider

When lenders calculate the minimum principal and interest repayment on a new loan, they calculate that repayment based on the term of the loan such that the principal loan balance is reduced to zero by the end of the term.  If your interest only loan term has run for 10 years and the total term of the loan was 30 years, when the loan reverts to principal and interest, your lender will calculate the principal and interest repayment over the remaining term, which in this case would be 20 years.  By way of example, if Tim and Suzy purchased an investment property with an investment loan of $500,000 at 6% per annum over 30 years, the minimum monthly principal and interest repayments would be $2,998.  However, if they decided to pay interest only for the first 5 years, at the end of that term, the minimum principal and interest loan repayment would be $3,222 ($500,000 at 6% per annum calculated over 25 years).  If you take out an interest only term, you need to ensure you will be able to afford the principal and interest repayments at the end of the interest only term.

There are going to be times and situations when interest only loans are appropriate for you.  However, now that interest only lending in most cases attracts a higher interest, now more than ever is the time to sit down with your mortgage broker and review options for your personal situation.