Looking at interest only loans

The governor of the Reserve Bank of Australia (RBA), Philip Lowe, has shown support for new housing affordability regulations from the Australian Prudential Regulation Authority, including limiting interest-only loans to 30% of all new loans supplied by banks and lenders.

Speaking at the RBA Board dinner following the central bank’s April meeting, which kept Australia’s cash rate at record-low 1.5% for the eighth straight month, governor Lowe commented that Australia’s interest-only home loans are “unusual” compared to the rest of the world:

“Over the past year, close to 40% of the housing loans made in Australia have not required the scheduled repayment of even one dollar of principal at least in the first years of the life of the loan; only interest payments are required. This is unusual by international standards. In some countries, repayment of at least some principal is required on all housing loans for the entire life of the loan. In other countries, interest-only loans are available only if the borrower has already contributed a fair degree of equity. So this is one area where Australia stands out. We are not unique in this area, but we are unusual.”

What is an interest only home loan?

An interest only home loan does exactly what it says on the tin – it’s a home loan where instead of making repayments that include both the loan’s principal and interest, you only pay interest to your lender instead.

Interest-only home loans are typically only available for a limited period of time. Many lenders limit interest-only repayments to 1 to 5 year stretches, though some lenders are willing to accept interest-only repayments for longer periods. Once an interest-only period is up, you’ll need to either apply to the lender to start a new interest-only period, or switch to paying principal and interest

Advantages of interest-only loans 

One of the most obvious advantages of an interest only loan is that you only need to pay the interest and not the principal, which makes the loan cheaper on a month to month basis. This can make interest-only loans attractive to some owner-occupiers looking to keep their costs down, whether they’re first homebuyers trying to firmly establish their finances, or borrowers seeking to free up more of their income to pay for a renovation or some other personal project.

According to governor Lowe, the flexible nature of Australia’s mortgages plays a significant role in the popularity of interest-only loans:

“Many people with interest-only loans make significant payments into offset accounts rather than explicitly paying down principal. This flexibility, which is of value to many people, isn’t available in most countries.”

By paying money into an offset account on an interest only loan, borrowers can reduce their interest repayments, and still access these funds if required much more easily than making a redraw or taking out a line of credit from a principal and interest home loan.

But it’s property investors that can really benefit from interest only loans. By using an interest-only loan to buy a property, an investor can enjoy low monthly repayments (potentially lowered further by an offset account), as well as tax benefits from negative gearing if the interest they pay is higher than the rental income they earn.

And even though an interest only loan doesn’t reduce the principal, the property’s value can still increase over time, so by the end of the interest-only period, the investor can sell and come out ahead, or reinvest using the resulting equity.     

Disadvantages of interest only loans 

While interest only loans may seem relatively affordable because you only need to pay your loan’s interest, if lenders repeatedly raise their interest rates, borrowers could find their monthly repayments quickly growing unaffordable. Similarly, if a lender declines to renew or extend an ending interest only period, borrowers could find themselves unable to afford their higher principal and interest repayments.

For owner occupiers, interest only loans may be more affordable in the short term, but because the principal isn’t being reduced during the interest-only period, this can mean the loan ultimately takes longer to pay off, and the borrower will pay more in total interest over the lifetime of the loan.

For investors, if their property’s capital growth is sluggish, or even drops in value (not impossible in specific areas) they could reach the end of their interest-only period without enough usable equity available to cover their costs.

How will the new regulations affect interest only loans? 

Among APRA’s new guidelines for banks, lenders and home loan providers are regulations to “limit the flow of new interest-only lending to 30% of new residential mortgage lending”, and to “manage lending to investors in such a manner so as to comfortably remain below the previously advised benchmark of 10% growth.”

Limiting the number of new interest-only loans (among other APRA regulations) should help to limit the number of Australians borrowing beyond their means and putting themselves into potentially risky financial positions if interest rates were to rise or house prices to fall.

These regulations should also contribute to reducing the overall level of risk in the Australian housing market, and help to stabilise the broader Australian economy in case of future economic downturns.  

Curbing interest-only loans is also expected to limit the impact of investors on Australia’s housing affordability, which according to governor Lowe, was already under pressure from high demand and limited supply in popular areas:

“Not surprisingly, the rising prices have encouraged people to buy residential property as an investment in the hope of ongoing capital gains. With global interest rates so low, many investors have found it attractive to borrow money to invest in appreciating residential property. This has reinforced the upward pressure on prices.”

“Like the earlier ‘speed limits’ on investor lending, these new requirements should help the whole system pull back to a more sustainable position. A reduced reliance on interest-only loans in Australia would be a positive development and would help improve our resilience.”

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Learn more about home loans

What is an interest-only loan? How do I work out interest-only loan repayments?

An ‘interest-only’ loan is a loan where the borrower is only required to pay back the interest on the loan. Typically, banks will only let lenders do this for a fixed period of time – often five years – however some lenders will be happy to extend this.

Interest-only loans are popular with investors who aren’t keen on putting a lot of capital into their investment property. It is also a handy feature for people who need to reduce their mortgage repayments for a short period of time while they are travelling overseas, or taking time off to look after a new family member, for example.

While moving on to interest-only will make your monthly repayments cheaper, ultimately, you will end up paying your bank thousands of dollars extra in interest to make up for the time where you weren’t paying off the principal.

What is 'principal and interest'?

‘Principal and interest’ loans are the most common type of home loans on the market. The principal part of the loan is the initial sum lent to the customer and the interest is the money paid on top of this, at the agreed interest rate, until the end of the loan.

By reducing the principal amount, the total of interest charged will also become smaller until eventually the debt is paid off in full.

How can I calculate interest on my home loan?

You can calculate the total interest you will pay over the life of your loan by using a mortgage calculator. The calculator will estimate your repayments based on the amount you want to borrow, the interest rate, the length of your loan, whether you are an owner-occupier or an investor and whether you plan to pay ‘principal and interest’ or ‘interest-only’.

If you are buying a new home, the calculator will also help you work out how much you’ll need to pay in stamp duty and other related costs.

Mortgage Calculator, Repayment Type

Will you pay off the amount you borrowed + interest or just the interest for a period?

What is the best interest rate for a mortgage?

The fastest way to find out what the lowest interest rates on the market are is to use a comparison website.

While a low interest rate is highly preferable, it is not the only factor that will determine whether a particular loan is right for you.

Loans with low interest rates can often include hidden catches, such as high fees or a period of low rates which jumps up after the introductory period has ended.

To work out the best value for money, have a look at a loan’s comparison rate and read the fine print to get across all the fees and charges that you could be theoretically charged over the life of the loan.

Interest Rate

Your current home loan interest rate. To accurately calculate how much you could save, an accurate interest figure is required. If you are not certain, check your bank statement or log into your mortgage account.

What is a guarantor?

A guarantor is someone who provides a legally binding promise that they will pay off a mortgage if the principal borrower fails to do so.

Often, guarantors are parents in a solid financial position, while the principal borrower is a child in a weaker financial position who is struggling to enter the property market.

Lenders usually regard borrowers as less risky when they have a guarantor – and therefore may charge lower interest rates or even approve mortgages they would have otherwise rejected.

However, if the borrower falls behind on their repayments, the lender might chase the guarantor for payment. In some circumstances, the lender might even seize and sell the guarantor’s property to recoup their money.

How do I take out a low-deposit home loan?

If you want to take out a low-deposit home loan, it might be a good idea to consult a mortgage broker who can give you professional financial advice and organise the mortgage for you.

Another way to take out a low-deposit home loan is to do your own research with a comparison website like RateCity. Once you’ve identified your preferred mortgage, you can apply through RateCity or go direct to the lender.

What is breach of contract?

A failure to follow all or part of a contract or breaking the conditions of a contract without any legal excuse. A breach of contract can be material, minor, actual or anticipatory, depending on the severity of the breaches and their material impact.

What happens when you default on your mortgage?

A mortgage default occurs when you are 90 days or more behind on your mortgage repayments. Late repayments will often incur a late fee on top of the amount owed which will continue to gather interest along with the remaining principal amount.

If you do default on a mortgage repayment you should try and catch up in next month’s payment. If this isn’t possible, and missing payments is going to become a regular issue, you need to contact your lender as soon as possible to organise an alternative payment schedule and discuss further options.

You may also want to talk to a financial counsellor. 

How often is your data updated?

We work closely with lenders to get updates as quick as possible, with updates made the same day wherever possible.

Remaining loan term

The length of time it will take to pay off your current home loan, based on the currently-entered mortgage balance, monthly repayment and interest rate.

Why was Real Time Ratings developed?

Real Time RatingsTM was developed to save people time and money. A home loan is one of the biggest financial decisions you will ever make – and one of the most complicated. Real Time RatingsTM is designed to help you find the right loan. Until now, there has been no place borrowers can benchmark the latest rates and offers when they hit the market. Rates change all the time now and new offers hit the market almost daily, we saw the need for a way to compare these new deals against the rest of the market and make a more informed decision.

What is a debt service ratio?

A method of gauging a borrower’s home loan serviceability (ability to afford home loan repayments), the debt service ratio (DSR) is the fraction of an applicant’s income that will need to go towards paying back a loan. The DSR is typically expressed as a percentage, and lenders may decline loans to borrowers with too high a DSR (often over 30 per cent).