Is your interest only loan the right choice?
The attraction of interest-only loans is obvious. Having a period of time – typically five years – where you’re not paying off the principal (the actual amount of the loan) means you have more money on hand to do other things. For first home buyers and investors, this usually means putting the extra cash into property improvements, repairs, furniture and other establishment costs.
All going well, when the five years is up and the loan reverts to P&I (principal and interest), you might be earning a bit more or have predictable rental income from your investment. It should then be easier to afford the additional repayments on your loan.
Sounds great. And that’s why interest-only loans were all the rage just a few years ago, and for a long time before that. But thing have changed, and depending on your circumstances, sticking with your interest-only loan might not be the best option.
In 2017 the Australian Prudential Regulation Authority (APRA – the government body that oversees the financial sector) was concerned about the number of interest-only loans, so put a limit on home loan lenders. Of all new home loans, only 30% were allowed to be interest only. Prior to this, around 40% of loans were interest only. With increased competition to get these loans, interest rates jumped in comparison to regular P&I loans. Many people switched from their interest-only loan to a P&I loan chasing the lower rates.
The regulatory change had the desired effect. Fewer interest-only loans were offered, and people with existing loans switched. The total pool of interest-only loans in the market dropped to around 30%.
Lowest rates ever
Interest rates are at historical lows. This makes it a great time to be paying off a loan. Many people are taking advantage of the low rates by paying off as much of their loan as possible.
For those that can afford to, chipping away at the principal with extra payments will have big advantages in the long term. A smaller loan means smaller interest payments in the future, even when rates rise again. Most interest-only loans don’t allow for extra repayments, which is another incentive for people to switch.
Even without paying more than the required repayments, there is a cost in the long run for having a five-year interest-free period at the start of your loan. For example, a $500,000 loan for 25 years at 4.5% interest will cost you almost $38,000 in extra interest over the life of that loan if you start with five years of interest-only payments. It’s a pretty high cost for a short-term up-front saving.
If you have an interest-only loan and want to find out how switching would affect your repayments, contact us at Mortgage Broker Melbourne. We’ll run the numbers, taking into account any fees you might need to pay to exit your existing loan, and show you how it will impact your repayments now, and across the remaining life of your loan.