Most residential home loans in Australia are established with Principal and Interest (P&I) repayments.  There are several reasons for this:

• Most borrowers are focussed on paying down their home loan to build their equity in property and reduce interest costs

• Interest rates for P&I loans are typically slightly lower than those for interest-only (IO) loans

• There is strong pressure put on the banks by the financial system regulator APRA to limit interest-only lending to minimise risk to the banking system

Where interest-only loans fit into the lending landscape

Repayments on interest-only loans are typically 43 to 50% lower compared with a P&I loan of the same amount.  There are circumstances where banks will offer an IO loan where the borrower has a clearly defined reason for choosing this repayment method, has sufficient equity in their property, and understands the additional risks inherent in this strategy.  These circumstances could be one of the following:

Property Investment

Property investment loans are most often tax-deductible. Property investors sometimes favour interest-only loans, particularly when they have other non-deductible debts such as their home loan to repay.  They often find it more tax-efficient to direct more of their surplus cash towards reducing their home loan rather than pay off both home and investment loans simultaneously.

Overall debt management

They may assist borrowers who have other higher cost debts (e.g. credit cards, overdrafts or personal loans) to direct more of their cash flow towards paying down and eliminating these debts. 

Short term cash flow management

Borrowers contemplating or experiencing short term reductions to their income may adopt interest-only repayments to help them retain their savings or reduce their cash outflows.  These circumstances could include periods of parental leave, time off for education, or short-term unemployment.

Important Considerations

What other factors should you consider before choosing an interest-only loan? 

1. Lower Borrowing Capacity – although repayments are lower, borrowers choosing interest-only loans can generally borrow less money.  This is because their loan is assessed against its P&I term.  So a 30 year loan with 5 years interest-only repayments will be assessed on loan repayments over 25 years

2. Higher Ultimate Repayments – when your loan reverts to P&I repayments at the end of the interest-only period, your P&I repayments will be higher than if you had adopted P&I repayments at the outset. For example, if you repay IO for the first 5 years of a 30 year loan your ongoing repayments will be 13% higher for the remaining 25 years.

3. Increased Equity Risk – borrowers adopting IO repayments are much more reliant upon the growth in the value of their property to build their equity.  Equally they are much more exposed if the value of their property drops and could find themselves in a situation where they cannot refinance their loan due to insufficient equity.

4. Financial Discipline – when misused IO loans can become a substitute for prudent financial management.  If adopting lower repayments results in increased spending on personal items there will ultimately come a day when you are more vulnerable to changes in your circumstances or increases in loan interest rates.

Interest-only loans are a powerful financial management tool when used correctly.  But like other power tools they can be dangerous when used for the wrong task, or by an inexperienced tradesperson.  If you would like more information, or assistance with some calculations on how interest-only loans might benefit you please contact our office.

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