When love doesn’t last: interest-only honeymoon loans
Some things are too good to be true. Interest-only loans fall into this category. You’ll soon discover that what you first see, and repay, is just the tip of the iceberg.
An interest-only loan in the residential housing context is a mortgage where the homeowner makes repayments only covering the interest portion of the loan. The ‘principal’ component of the loan isn’t paid – which is the amount the property is worth.
This type of loan comes with great benefits, like lower repayments at the start, tax deductions for investment properties, and an option for a construction loan. But (yes, there’s always a but), the repayments are higher when the interest-only period ends. You’ll pay more over the lifetime of the loan, and the interest rate may be higher than the principal.
Two couples, each borrow $750,000 over 30 years.
Let’s say Sam and Steph go interest-only for five years. Their interest rate is 4.25%, so their monthly payment during the interest-only period is $2,650. Once the five years is up, they begin their monthly $4,065 payments. Over 30 years, they’ll pay $1,378,000.
Compare this to Scott and Nicole. Their interest rate is 3.95%. With a monthly payment of $3,500 over 30 years, they’ll pay $1,280,000 – over $100,000 less than the couple who ‘honeymooned’ for the first five years.
Consumer spending and economic growth is squeezed by low wages and regulatory tightening on lending – which is putting a strain on the stability of the financial system, Morgan Stanley’s analyst Richard Wiles believes. He labeled interest-only loans as a ‘weak spot.’
Last year, APRA put a limit on interest-only lending to 30% of total new residential mortgage lending, put restrictions on interest-only lending on loan to value ratios (LVRs) above 80%, and asked for strong scrutiny of interest-only loans at an LVR above 90%.
Banks have raised their rates on these loans by around 90 basis points in a bid to dampen demand – addressing the risk that’s become greater than direct credit losses in housing, as homeowners are more likely to sell the property if rates rise. There’s no wonder with monthly repayments for these loans jumping between 30-60% at the end of the interest-only period.
monthly repayments for these loans jumping between 30-60% at the end of the interest-only period.
Good things take time…
While it’s tempting to take advantage of interest-only loans so you can get into your house (or add to your investment portfolio) quicker, it’s important to have a long-term mindset.
- Can I afford the higher repayments when the interest-only period ends?
- Can I trust myself not to dip into my offset account?
- Will the short-term benefits outweigh the long-term costs?
- If I can't afford a principal and interest loan, is now the right time to borrow?
This is not to say that interest-only loans are a no-go. Rather, it’s just a matter of educating yourself and knowing your situation once the five years is up. Some options are lowering your payments by putting extra funds into an offset account, finding a cheaper home, or reducing the interest-only period to lower long-term payments.
For some investors, they are now experiencing the end of the honeymoon period and coming off the interest-only mortgages and finding a rude shock as banks are now more strict on their lending criteria. However it is not impossible to refinance on another interest only loan. You need a good mortgage broker who knows the banks appetite, if you need some help then shout.
Want specific advice tailored to your situation? Get in touch now.