The perks and pitfalls of interest only loans

27th Jul 2016By: Adrian Sheahan

Are interest only loans a good option? It’s a common question, and the short answer is that interest only loans often provide unintended downside risk, and should only be recommended under specific circumstances.

This stance is backed by the banking regulator, APRA, with lenders now required to detail why they have provided a borrower with an interest only repayment structure, and why it’s suitable for their situation and needs.

So when are interest only loans suitable? First, let’s consider the potential benefits of a loan where the repayments during the initial period of the loan (usually up to five years) are interest only, before converting to Principal and Interest for the remaining term.

The benefits

  • As there is no requirement to reduce the loan principal, the repayments during the interest only period are less than those under a Principal and Interest repayment structure, providing improved cash flow for the borrower.
  • It can be used by investors who rely upon growth in the property value (capital gain) to create wealth, while minimising repayments and maximising tax deductions against the asset in the short term. This is an important tool in a negative gearing strategy.
  • Interest Only loans allow borrowers with reduced income in the short term (e.g. during periods of parental leave or a career break) to minimise their loan repayments. This can release the financial pressure on the borrower until they return to work, or re-establish their income stream.
  • It can allow investors to use more of their income to repay loans where the loan costs are non-deductible, such as their owner-occupied property loan. However this is a strategy that needs to be discussed with a financial adviser or accountant to confirm it suits the applicant’s situation.
  • If the borrower’s property is on the market, or they have a large sum of money due to them in the short term, interest only repayments may be suitable to relieve cash flow pressures pending receipt of the money or sale of the property.

Interest only loans are not without risk however – so what are the pitfalls of interest only repayments?

The pitfalls

  • The obvious negative outcome is that the loan balance is not reduced. Therefore, if the property value does not rise, or worse, it decreases in value, the borrower’s equity in the property may be reduced, or in extreme circumstances, the loan may even exceed the property value. For investors, that leaves their strategy in tatters and for the home owner, it leaves them owning less (or none) of what’s potentially the biggest purchase of their life.
  • When the interest only period expires and the repayments change to principal and interest, the loan repayments will increase significantly, leaving the borrower at risk of being unable to afford the loan and of being forced to sell the property to pay out the debt. The repayments increase for two reasons;
  1. The new repayments will include a principal repayment component over and above the interest amount being paid prior to the change.
  2. The principal and interest repayments are calculated on the remaining term of the loan, not the original term. So, the borrower has the same amount of debt to repay as when they took the loan, but a shorter period to do so.

To illustrate these points, consider the following scenario.

Mr and Mrs Applicant sign up for a loan of $500,000 over 25 years with an interest rate of 5.00%. They opt for a five-year interest only period, before converting to principal and interest repayments for the remaining loan term.

During the interest only period, repayments will be approximately $2,085 per month. When the initial five-year interest only period expires, the repayments on a principal and interest basis will jump to $3,299. That’s an increase of $1,214 per month for the remaining 20 years, and a lot of money in anyone’s language.

The overall cost of the loan will also be significantly higher under this scenario.

If the loan was repaid over 25 years on a monthly principal and interest basis, the total cost would be $876,885. By electing repayments on a five-year interest only basis before reverting to principal and interest repayments, the total cost is $916,946, a difference of over $40,000!

Interest only loans often have a higher interest rate. In response to APRA’s concerns, many lenders now charge a premium on the interest rate for interest only borrowings, lifting the rates by as much as 0.25% on interest only facilities.

So, while there are very real circumstances and strategies when interest only borrowings are the most suitable loan structure, the above example demonstrates the risks associated with interest only loans and why APRA are concerned about their use – particularly when the loan is for the borrowers principle place of residence.

For Switzer Home Loans (and for any good lender), the primary objective is to provide the loan product that best matches the borrowers needs and maximises their wealth. Interest only loans do not always meet this criteria, so if you are considering a loan with interest only repayments, speak with us, your financial adviser, or a loan specialist to identify the right structure for you.

Adrian Sheahan is the manager of lending operations at Switzer Home Loans. Contact him today for a free loan health check.