Interest only loans are where you merely pay back the interest of a loan to the lender – so if you borrowed $500,000 and made repayments for five years, your balance would still be $500,000. They are designed predominantly for investors for cash flow and tax deductibility purposes.
In March 2017, the Australian Prudential Regulation Authority (APRA) put a restriction of 30% of all new residential interest only loans accepted by the banks. The cap was placed to prevent borrowers over-leveraging themselves along with being prudent in a volatile property market Australia-wide.
In order to control the demand for interest only lending, banks applied two levers – interest rates and Loan to Value Ratios (LVR).
Interest only lending is now anywhere from 0.25% to 1.00% higher in interest than Principal and Interest rates. This can be quite significant on larger loans, i.e. 0.50% on a $500,000 30 year term loan is approx. $150 per month more expensive.
Banks also now have maximum LVRs in place for interest only lending, i.e. most lenders will only give interest only loans below LVRs of 80%. Interest only loans for owner occupiers are scarce and borrowers would need a good reason for approval such as going on maternity leave or home renovations. However even in these circumstances, interest only loans will only be given for a short term of say one to two years.
What to look out for
Because of these changes, borrowers need to keep a close eye on what rate their bank is charging as there could be a significant difference between what they are paying, what their bank can offer and what is on the market.
Interest only loans are generally only available for five years and then will revert to principal and interest. This can be a significant difference in repayments, so for example repayments on $500,000 over a 25 year loan term are just under $1,000 per month, which can be a financial burden if not accounted for. RBA figures show that there will be approx. $120 billion of interest only loans reverting back to principal and interest over the next three years.
Call to action
Borrowers on interest only need to check with their lender and confirm how long they have before the loan is reverted back to principal and interest in order to allow for the difference in payments. For an investment loan, if your bank refuses to extend the interest only period, other banks may be able to accept interest only for a further five years, however you as a borrower need to be very mindful that whilst on interest only, you are not reducing any of the debt and will need another exit strategy.
With banks continuing to tighten their lending criteria, trying to refinance could also pose a potential issue. So looking at your options sooner rather than later could save potential future cash flow problems.
If your mortgage provider does not help with your requirements, get in touch with your local mortgage professional who has access to a suite of lenders to see what other options you may have.
Raj Ladher from Tomorrow Finance is a mortgage expert with over 11 years’ experience both in the UK and Australian mortgage markets. Accredited with the Mortgage and Finance Association of Australia (MFAA) and access to numerous lenders, Raj specialises in all types of mortgages, from first homeowners to investors increasing their portfolio. For more, email firstname.lastname@example.org