The Pros and Cons of Interest-Only Home Loans in Australia

Interest-only home loans can look appealing with their drastically reduced first-year payments. Though a $500,000 mortgage at 4.8% interest can be paid for with only $2,010 monthly payments during the interest-only period, this figure then spikes considerably to $3,250 once the payments on the principal begin.

Your choice among different home loans in Australia can truly affect your financial future. Although interest-only repayments can ease your short-term cash flow, they come with major problems in terms of equity creation and long-term spending.

What Are Interest-Only Home Loans in Australia?

Interest-only home loans in Australia are loan products that allow borrowers to only pay the interest part of their mortgage for an agreed term of usually 1–5 years for an owner-occupier. When that term is finished, the loan will automatically revert to principal and interest repayments.

Interest only terms can also apply for property investors for up to 10 years (interest only loan terms generally available to investor/creditworthy borrowers during that period). As of now, they comprised approximately 23% of owner-occupier lending and 64% of investor lending in Australia.

The significant differences between interest-only home loans and principal and interest loans are the term of the loan. In an interest only loan, all payments go towards servicing (paying) the interest on the whole loan amount. Accordingly, the loan balance does not decrease over the interest only portion of the loan since no principal payment is being made.

At the end of the interest-only period, borrowers have the option to:

• Extend the interest-only term (approval subject to the lender)
• renegotiate with another lender
• Change to principal-and-interest repayments

Lenders generally need up to date financial information whether in relation to current income and expenditure prior to approving an extension of the interest-only period. The processing of that application is unlikely to take longer than four weeks, so it is better to have a plan.

If you are considering switching to principal-and-interest repayments, keep in mind you will have higher monthly repayments, as the principal must be repaid over a shorter remaining period of your loan. It is up to the borrower to also keep an eye on the end date of the loan’s availability and plan accordingly to make that transition easier.

Benefits of Interest-Only Loans

Real estate investors all across Australia favor interest-only loans because of their special financial advantages. Lower monthly installments are among the most significant advantages. Tax deductibility is a strong persuasive factor for investors to make use of interest-only loans. The Australian Taxation Office guarantees that interest on investment properties is fully tax-deductible.

Statistics show that average investors receive over $9,000 of interest repayment as a tax deduction per financial year. For rent-seeking property investors, interest-only loans have excellent cash management. Interest-only loans are particularly helpful to high-income investors by making them more tax-efficient. Rather than paying principal with dollars after taxes, the investor can claim maximum deductions during years of high income. Interest-only loans also make property investment strategies based on capital appreciation easier. With less payment, investors can invest in buying additional properties or diversifying their investment portfolio. Risks and Challenges

Even as they initially attract people, interest-only home loans in Australia have high risks that require stern attention. New findings from the Reserve Bank of Australia indicate that these loans include higher credit risks, mainly due to borrowers becoming more indebted over the life of the loan.

One of the fundamental problems arises when the interest-only period expires. The reason that during the interest-only period no payments of principal are made is a big problem. Unless house prices rise, the borrowers do not build up any equity in their housing property. This becomes very problematic if house prices decline and they find themselves in negative equity.

Interest rates tend to be higher on interest-only loans, at around 0.30% above principal and interest rates annually. It also involves paying the entire principal for the duration of the interest-only period, keeping total interest paid throughout the life of the loan significantly greater.

The Australian Prudential Regulation Authority now requires lenders to test borrowers’ capacity to repay both the interest and principal in the ‘residual’ phase, thereby lowering the peak borrowing capacity. It is this stringent step aimed at checking future financial burden on the borrowers.

Conclusion

Interest-only home loans are a highly developed financial option that requires careful investigation of your long-term circumstances and goals. While the loans possess attractive benefits like lower upfront payments and tax advantages for investors, they come with very high risks that require close scrutiny.

The potential for the payment shock once the interest-only duration expires, along with higher overall interest costs, makes planning essential. So, you must evaluate your financial picture today and your potential earning power before you make this type of loan.

In the end, it is all about having a plan to convert from making interest only payments to making principal and interest payments. The mortgage experts at Efficient Capital can certainly help you assess your specific situation and understand whether interest-only home loans might be a part of your financial goals. Their experience team will work closely with you through the particulars of the many types of loans so you can make a wise choice with respect to your overall, long-term financial health.

Thus, regardless of whether your motivation is to maximize tax advantages as an investor or you simply want flexibility and control over your payments and are good with equity on your home, getting the advice of experienced financial experts will help you in making the right decisions while minimizing the risk of making a bad choice.