In 4Q15 the value of interest only loans issued in Australia increased by 84% over the previous three years (vs. only 20% growth in the value of principal and interest loans).
In the December 2014 quarter interest only loans accounted for 43% of all new home loans issued. Of these, 41% were issued to owner occupiers and the remainder were issued to investors.
Interest only loans have clear and sensible benefits for property investors, but only when used sensibly will they be advantageous for owner occupiers.
An overview of Interest Only loans
As the name implies, interest only loans are where the borrower only pays interest on the loan over the interest only term (generally 3 or 5 years), without paying any principal.
After the interest only term ends the borrower starts paying principal as well as interest, so the repayments increase – and these repayments are a lot higher because the full principal amount has to then be paid down over a shorter period of time.
Consider this example:
As illustrated above, if John and Kate take a $400k principal & interest (P&I) loan at 5% over 30yrs, their monthly repayments are $2,147. If they instead choose a 5yr interest only 30yr loan at 5% their repayments are only $1,667 over the first 5yrs (lower) but then from years 6-30 they increase to $2,338 (much higher).
When determining whether John and Kate can afford the loan, it is important to assess the P&I repayment requirements, because the interest only amounts are artificially low.
Furthermore, even if the interest only option is affordable over the life of the loan, the early cost savings are attractive but they do come at a cost – over the life of the loan John and Kate pay $27,000 more with the interest only option ($800 total vs. $773k).
Let’s now look at John and Kate’s equity position with the respective loan scenarios.
The main disadvantage with the interest only loan is that John and Kate aren’t paying down their actual principal/mortgage. After 5yrs, despite having paid $100k of interest, they will still owe $400k on their property. With a standard P&I mortgage, after 5yrs their principal would have been paid down to $367k, meaning that they have created $33k equity.
Interest only loans have clear benefits for property investors, but owner occupiers have to be more careful
Despite the drawbacks discussed above, interest only loans can be beneficial for property investors.
Property investors are less concerned about reducing their principal balances:
- their interest payments are tax deductible, so as long they continue making interest repayments they continue to enjoy the tax benefits of property investment
- assuming the value of their properties increase (capital growth), they can sell their investments for a profit before (or shortly after) the higher repayments kick in; and
- the money saved through lower interest only payments can be put to better use (e.g. paying down non-tax deductible debt, or to pursue other higher yielding investments)
But for owner occupiers these benefits don’t necessarily apply:
- their interest repayments are not tax deductible
- they are less likely to sell in the short term, therefore they will be faced with the higher repayments once the interest only period expires; and
- lower repayment savings are more likely to be spent on non essential discretionary items
It’s no secret that house prices throughout many parts of Australia, particularly in Sydney and Melbourne, have had a great run. It is becoming increasingly difficult for owner occupiers to get into the housing market, as it’s becoming more expensive. So unfortunately an increasing number of owner occupiers are choosing interest only loans purely as a means to enter the market. This is dangerous. Particularly if interest rates rise and/or property prices fall these borrowers will be affected the worst.
But interest only loans can benefit owner occupiers.
There are many articles and commentators calling for the banning of interest only loans for owner occupiers. They are always very alarmist though and fail to mention the ways in which interest only loans can be used sensibly by owner occupiers.
For owner occupiers the savings from lower interest only repayments can be used to:
- increase the balance of an attached offset account, which reduces the borrower’s monthly repayments of non-deductible interest
- directly pay down the principal balance of the home loan outstanding, thus reducing non-deductible debt in the form of “accelerated payments”
- pursue other high yielding investments
These are just three examples of interest only loans being sensible strategies for owner occupiers. Each can make and/or save borrowers a lot of money. It’s not about taking the repayment savings and going off to buy new clothes or cars.
Effective use of interest only loans require sound advice and execution — this is really what’s most important. Without the right advice all borrowers faces many problems, the least of which are interest only loans.
