Interest Only Home Loans

Welcome to the finance update for the week ending 19 August, 2023.

For those of you who follow mortgage interest rates with a keen eye, you may have noticed that in the last week, rates have been lowered by a few lenders. Two of the big lenders, CBA and Macquarie, have reduced their 1 year fixed rates, while second tier lender Pepper Money has pushed their standard variable rate down a little. Whilst not something to celebrate too hard about, it does suggest that banks are starting to adjust their thinking about the near term outlook. This week’s unemployment figure creeping slightly up would add to their confidence. But let’s not hold our breath!

In this week’s newsletter, we take a look at interest only loans. They make a lot of sense in some circumstances, but as always, there can be a sting in the tail.

Interest-only home loans in Australia offer borrowers the option to pay only the interest on their mortgage for a specified period, typically between one and five years. While they can provide certain advantages, they also come with notable drawbacks:

Pros:

Lower Initial Payments: During the interest-only period, borrowers have lower monthly payments compared to traditional principal and interest loans, which can help with short-term affordability, particularly for investors or those with irregular income.

Investment Flexibility: Investors may use interest-only loans to free up cash for other investments, as the lower payments can be directed towards alternative ventures.

Tax Deductibility: Interest payments on investment property loans may be tax-deductible in certain cases, potentially offering tax benefits to investors.

Cons:

Deferred Principal Repayment: Interest-only payments do not contribute towards reducing the loan’s principal amount, meaning borrowers don’t build equity during the interest-only period if the property value doesn’t change in the corresponding period.

Higher Total Interest Costs: Since the principal balance remains unchanged during the interest-only phase, borrowers end up paying more in total interest over the life of the loan compared to a traditional loan with regular principal payments.

Risk of Property Value Changes: If property values decline, borrowers with interest-only loans could find themselves owing more on the property than it’s worth, making it challenging to refinance or sell.

Potential Payment Shock: After the interest-only period ends, borrowers must start making higher principal and interest payments, which could lead to payment shock if they haven’t adequately prepared for the increase.

Limited Lender Options: Interest-only loans have become less common due to regulatory changes, and borrowers may find fewer lenders willing to offer them.

Qualification Challenges: Borrowers may face stricter eligibility criteria or higher interest rates for interest-only loans, potentially limiting access to this option.

Interest-only loans can be suitable for certain scenarios, such as investors aiming for short-term cash flow management, but they require careful consideration of long-term financial implications and potential risks.

Borrowers should thoroughly assess their ability to manage the transition to principal and interest payments before getting too excited about how ‘affordable’ the repayments are at the outset.

Any changes in interest rates from last week are highlighted in orange.

Note – Increases announced by lenders as a result of RBA decisions normally take 1-2 weeks to come into affect.

Variable

The rates below are based on a $500,000 loan, with the borrower making principle and interest payments with a loan term of 30 years. The rates quoted may vary depending on the borrowers LVR.

1 Year Fixed

The rates below are based on a $500,000 loan, with the borrower making principle and interest payments with a loan term of 30 years. The rates quoted may vary depending on the borrowers LVR. At the end of the three year fixed period, the borrowers interest rate will revert to a standard variable rate for the life of the loan.