A recent review by ASIC found that lenders providing interest-only (IO) mortgages need to lift their standards to meet important consumer protection laws. ASIC found that demand for IO loans had grown by 80% since 2012. Click here to read the full report and findings by ASIC.
The purpose of my blog today is to set the record straight in layman terms and to discuss the pros and cons of IO loans.
What is an Interest Only loan?
As the name suggests, and IO home loan requires you to only pay the interest on the amount you have borrowed. Usually for a pre-determined term (5 years is the most popular).
At the end of the IO term, the loan reverts to P&I repayments which means you start to repay the capital (borrowed money) as well as the interest. The interest portion of your repayment is effectively the bank’s income/revenue for lending you the money.
What are the risks with Interest Only loans?
IO home loans can be a trap in the wrong hands. At first the loan repayments will seem lower as you are only paying interest and not principal. Then once the repayments change to P&I, all of a sudden you have to find the extra cash flow to pay not only the interest, but also the principal.
The issue here is that at the end of the IO term, the loan repayments will be higher as the amortisation period is for a lesser period. For example, if you take out a 30 year home loan with a 5 years IO repayment term, the P&I repayments will be amortised over 25 years (and not 30 years).
The other risk with IO loans is that during the IO period you do not reduce the capital (borrowed money) and therefore at the end of the IO term you still owe the same amount of money you borrowed. The risk here is that if you buy the wrong property and the property hasn’t gone up in value, then you risk having no equity in the property despite making loan repayments every month.
What are the benefits of Interest Only loans?
IO loans are a significant benefit for investors. IO loans can play a big part in tax planning as well as preserving cash flow to enable you grow your investment portfolio.
For example, let’s say you have a $500k home loan and a $400k investment loan. Making IO repayments on your $400k investment loan is smart as you can direct more cash (additional repayments) towards your $500k home loan. The goal here is to pay off your home faster.
Further, the interest expense on your home mortgage is not tax-deductible, therefore this is the debt you are likely to want to pay off first.
IO loans are most popular with property investors because repayments are lower, therefore cash flow is a major benefit of IO loans for Investors. You are only paying interest and not the loan principal. The benefit here is more cash flow to use towards your overall investment portfolio.
What’s best for me?
It all depends on your strategy. IO loans are most popular with property investors, and P&I loans are usually best suited for home mortgages.
Having said that IO loans can benefit both camps (owner-occupier home loans and investment loans). Reason being is that lower loan repayments allows you to :
Pay off other non-deductible personal debts faster, such as your home loan, credit cards, car or personal loans
Save a deposit faster for your next property purchase
Build a financial buffer and store it away for a rainy day (e.g. pay more than the minimum and store the extra repayments in your redraw or offset account)
Pay off the loan principal at your discretion either on a regular basis on in lump sumps
If you’re considering an IO loan think carefully about whether it’s the right strategy for you. Seek professional mortgage advice to ensure that your longer term financial goals are not compromised. Loan structuring is key to getting ahead financially!