Interest only loans and what you need to know

No doubt you have heard plenty about interest only loans in recent weeks.

It seems you can’t open the paper, turn on the news or get online without seeing or hearing something about the state of the property market and the changes to interest only loans.

So, what’s been happening and what do all the changes mean for you, your mortgage and, most importantly, your hip pocket?

Before we explain what’s been happening in the interest only space, it might be worth taking a few steps back.

If you don’t have an interest only product, you would be forgiven for not knowing what the product is and how it works.

In a nutshell, an interest only loan is just like any other mortgage product. Borrowers with an interest only product are still required to make regular mortgage repayments. But, as the name would suggest, all the borrower is doing is making an interest repayment. In other words, their regular mortgage repayments do not help pay off the principal debt.

Because borrowers with interest only loans are effectively not paying off their mortgage at all, these products usually only last for a period of time (generally up to 5 years).

Example: Bob borrows $500,000 from his preferred lender and is required to pay it back over 30 years. At the beginning of the loan, he selects an interest only product with a 5-year term. Throughout the first 5 years, Bob doesn’t repay a single cent off his $500,000 loan. Once the 5-year interest only product comes to an end, Bob moves into a principal and interest mortgage product. He now has 25 years to pay back the entire $500,000 loan plus interest.

From this example, we can see that interest only loans aren’t the ideal home loan solution for everyone. Some borrowers would ideally want to start paying down their principal mortgage debt from day one.

Of course, there are many different borrowers who would actually benefit from having an interest only loan.

First, these loans are very popular with property investors. The fact is, interest repayments are tax deductible – principal debt repayments are not. As such, there are significant tax advantages associated with interest only loans for investors.

For owner occupiers, interest only loans allow them to reduce their mortgage repayments for a set period of time. This helps owner-occupiers free up their cash flow – cash that can then be used for other things like paying down higher interest rate loans (like credit cards, personal loans, car loans, etc) or even funding renovations.

Now that you know what an interest only loan is and who it may benefit, you’re probably thinking: "Ok, so what’s been happening in this market lately?"

Well, to cut a long story short, the Australian Prudential Regulation Authority (APRA) decided earlier this year that lenders were offering too many interest-only products.

APRA wanted to ensure only those borrowers who had a ‘good reason’ for wanting an interest only loan received this type of product. APRA did not want borrowers avoiding their debt obligations unnecessarily.

As such, the regulator wrote to Australia’s lenders in March 2017 and asked that they limit their level of interest only lending to 30% of all new loans written.

In response, most of Australia’s lenders significantly increased their interest only home loan rates in a bid to cool this type of lending.

Some lenders lifted their interest only rates by as much as 40 basis points. In addition, many lenders tweaked their interest only product policies so that these products were not as enticing as the principal and interest products on offer.

As a result of these changes, demand for interest only loans plummeted.

According to Mortgage Choice data, interest only loans accounted for 14.64% of all home loans written throughout the month of September 2017 – down from 35.95% in April 2017.

In recent weeks however, things have started to turn a corner when it comes to interest only lending.

While all of Australia’s lenders are acutely aware that they have a 30% cap to which they need to adhere, for some at least, it seems the pendulum may have swung a little past its centre point.

As such, many of Australia’s lenders are now working to bring the pendulum back into place by reducing their interest only interest rates.

Throughout October and November, we saw a number of lenders cut their interest only pricing in a bid to attract more of this business.

This communicates two clear points:

1) There are still plenty of lenders happy and willing to offer interest only products; and

2) Now is a great time for anyone thinking of taking out an interest only product to review their options.

If you or anyone you know is looking for more information about what is happening in the interest only space, make sure you give us a call. We're happy to help!

Posted in: Home loans

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