Episode Details

Most investors and some homeowners have interest only loans. However, the option to repay interest only doesn’t last forever. Most mortgages have a term of 30 years. Typically, the first 5 years is interest only. After that term has expired, repayments automatically convert to principal plus interest.

If you have an interest only loan that is approaching the maturity of its term, what are your options?

The government forced banks to curb interest only loans

The volume of interest only mortgages peaked in early 2017 when they accounted for approximately 40% of all new mortgages. The government (APRA) then stepped in and introduced a new benchmark which stipulated that the proportion of new interest only loans provided by banks must be less than 30% of all new loans. Most banks achieved this target by mid-2018 and currently only 20% of all new loans are structured with interest only repayments. As such, APRA subsequently removed this benchmark in December 2018.

The banks dissuaded borrowers away from interest only loans by doing four things:

1. They increased variable interest rates. Until recently, variable interest rates for interest only loans were 0.42% higher than their principal and interest counterparts. That gap has only recently reduced to 0.34% because most of the banks passed the full 0.25% October RBA rate cut. I predict that this cap will continue to reduce over time.

2. Banks made it more difficult to roll-over to a new interest only term by requiring borrowers to go through a full application process.

3. Almost all banks reduced the maximum interest only term to 5 years. Previously banks would offer interest only terms of up to 10 years – and a few banks even offered 15 years.

4. Lenders tightened credit parameters e.g. they have become very reluctant to allow interest only repayments for owner-occupier loans.

The banks are starting to loosen up on interest only

Over the past few months, we have noticed that some lenders have marginally loosened credit policies in respect to interest only loans. Some lenders no longer require borrowers to go through a full application process if they request a second interest only term. Also, some banks will now offer interest only terms of up to 10 years to investors only.

Do interest only loans still make sense?

Interest only loans increase your flexibility. Whilst the minimum payment is limited to just the interest, it does not mean that you are not allowed to make principal repayments. In fact, you can make principal repayments at any time. Better still, attach an offset account to your mortgage and your cash savings will reduce the interest cost too.

Investors are particularly attracted to interest only loans for two primary reasons. Firstly, if they have a (non-tax-deductible) home loan, they can direct all their cash flow towards repaying it first, before they repay any investment debt. Secondly, it reduces the monthly cash flow cost of their investment. This means that have more cash to invest in other assets (or service higher levels of borrowings).

The additional benefit of an interest only loan is that your monthly repayment amount is directly linked to your net balance. Therefore, if you have repaid a portion of your loan principal or have monies in offset, your repayment will reduce accordingly. However, the dollar value of principal and interest loan repayments are fixed as they are calculated using the loan amount, not the actual balance. Most people prefer the flexibility that interest only loans provide.

So, are you suggesting that we never repay an investment loan?

No, not necessarily. Of course, you must consider debt repayment/management when formu