The hidden pitfalls of interest only loans
Financial Planning | 18/01/2018 |
5 min read
Interest-only loans came under scrutiny in 2017. In a bid to take the heat out of the property market and protect consumer interests, banking watchdog APRA (Australian Prudential Regulation Authority) introduced new limits to the volume of interest-only loans that banks and other lenders can offer.
When the banking regulator starts asking questions about interest-only loans it’s a good sign that residential investors should too. But what do the new changes actual mean? And what are the implications for people looking to get on the property ladder?
How do interest-only loans work?
First up, interest-only isn’t a type of home loan. Rather, it’s a payment option.
Borrowers can choose between principal and interest (P&I) payments, where part of each repayment goes towards paying down the loan balance, or interest-only payments comprised solely of interest charges with no reduction in the loan principal.
Two main benefits of interest-only loans
Interest-only loans offer two key advantages. Firstly, the repayments are lower than for P&I. Secondly, investors can maximise their tax deductions, by claiming the interest payments.
This explains why investors have traditionally favoured interest-only loans, especially those who plan to sell the property for a profit and pay the loan off using the sale proceeds.
Why the clampdown on interest-only loans?
The surging property prices in Sydney and Melbourne have seen an increasing number of home owners looking at interest only loans as way to lower the cost of entry. While this can make home ownership more affordable, there are risks.
Interest-only loans rely on rising values to build equity in your home. But if the market dips you could face negative equity – where you owe more on your property than the place is worth. The other risk is you are never really paying off that debt. And for home owners, aiming to own your place debt-free at some stage – preferably before retirement, is a worthwhile ambition.
Interest-only lasts for a limited time
Whatever your circumstances, bear in mind that lenders usually permit interest-only payments for a limited time − typically up to five years. After this, you’ll likely have to reapply to continue with interest-only payments or revert to principle and interest repayments.
So while interest-only loans may be suitable for investment purposes, they’re not recommended for owner occupiers. If you plan to own your place mortgage-free at some stage, steadily paying off a home loan with principal and interest repayments makes good financial sense.
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