Looking at interest only loans

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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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.

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.

What is the average length of a home loan?

Most Aussie lenders offer home loans with a 30-year term, meaning that you should pay back the full loan amount and the interest you owe on the amount in 30 years. 

However, home loans can also have a shorter or longer term. They may be as low as ten years or up to 45 years, depending on the product and lender. 

It’s worth remembering that a longer loan term usually means you’ll end up paying a lot more interest in total, but your scheduled repayments may be more manageable. In contrast, you could opt for a shorter loan term if you are comfortable making large repayments in exchange for paying less interest over the term of the loan.

Why does Westpac charge an early termination fee for home loans?

The Westpac home loan early termination fee or break cost is applicable if you have a fixed rate home loan and repay part of or the whole outstanding amount before the fixed period ends. If you’re switching between products before the fixed period ends, you’ll pay a switching break cost and an administrative fee. 

The Westpac home loan early termination fee may not apply if you repay an amount below the prepayment threshold. The prepayment threshold is the amount Westpac allows you to repay during the fixed period outside your regular repayments.

Westpac charges this fee because when you take out a home loan, the bank borrows the funds with wholesale rates available to banks and lenders. Westpac will then work out your interest rate based on you making regular repayments for a fixed period. If you repay before this period ends, the lender may incur a loss if there is any change in the wholesale rate of interest.

What do people do with a Macquarie Bank reverse?

There are a number of ways people use a Macquarie Bank reverse mortgage. Below are some reasons borrowers tend to release their home’s equity via a reverse mortgage:

  • To top up superannuation or pension income to pay for monthly bills;
  • To consolidate and repay high-interest debt like credit cards or personal loans;
  • To fund renovations, repairs or upgrades to their home
  • To help your children or grandkids through financial difficulties. 

While there are no limitations on how you can use a Macquarie reverse mortgage loan, a reverse mortgage is not right for all borrowers. Reverse mortgages compound the interest, which means you end up paying interest on your interest. They can also affect your entitlement to things like the pension It’s important to think carefully, read up and speak with your family before you apply for a reverse mortgage.

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.

What are the features of home loans for expats from Westpac?

If you’re an Australian citizen living and working abroad, you can borrow to buy a property in Australia. With a Westpac non-resident home loan, you can borrow up to 80 per cent of the property value to purchase a property whilst living overseas. The minimum loan amount for these loans is $25,000, with a maximum loan term of 30 years.

The interest rates and other fees for Westpac non-resident home loans are the same as regular home loans offered to borrowers living in Australia. You’ll have to submit proof of income, six-month bank statements, an employment letter, and your last two payslips. You may also be required to submit a copy of your passport and visa that shows you’re allowed to live and work abroad.

Cash or mortgage – which is more suitable to buy an investment property?

Deciding whether to buy an investment property with cash or a mortgage is a matter or personal choice and will often depend on your financial situation. Using cash may seem logical if you have the money in reserve and it can allow you to later use the equity in your home. However, there may be other factors to think about, such as whether there are other debts to pay down and whether it will tie up all of your spare cash. Again, it’s a personal choice and may be worth seeking personal advice.

A mortgage is a popular option for people who don’t have enough cash in the bank to pay for an investment property. Sometimes when you take out a mortgage you can offset your loan interest against the rental income you may earn. The rental income can also help to pay down the loan.

How is interest charged on a reverse mortgage from IMB Bank?

An IMB Bank reverse mortgage allows you to borrow against your home equity. You can draw down the loan amount as a lump sum, regular income stream, line of credit or a combination. The interest can either be fixed or variable. To understand the current rates, you can check the lender’s website.

No repayments are required as long as you live in the home. If you sell it or move to a senior living facility, the loan must be repaid in full. In some cases, this can also happen after you have died. Generally, the interest rates for reverse mortgages are higher than regular mortgage loans.

The interest is added to the loan amount and it is compounded. It means you’ll pay interest on the interest you accrue. Therefore, the longer you have the loan, the higher is the interest and the amount you’ll have to repay.

When does Commonwealth Bank charge an early exit fee?

When you take out a fixed interest home loan with the Commonwealth Bank, you’re able to lock the interest for a particular period. If the rates change during this period, your repayments remain unchanged. If you break the loan during the fixed interest period, you’ll have to pay the Commonwealth Bank home loan early exit fee and an administrative fee.

The Early Repayment Adjustment (ERA) and Administrative fees are applicable in the following instances:

  • If you switch your loan from fixed interest to variable rate
  • When you apply for a top-up home loan
  • If you repay over and above the annual threshold limit, which is $10,000 per year during the fixed interest period
  • When you prepay the entire outstanding loan balance before the end of the fixed interest duration.

The fee calculation depends on the interest rates, the amount you’ve repaid and the loan size. You can contact the lender to understand more about what you may have to pay. 

When do mortgage payments start after settlement?

Generally speaking, your first mortgage payment falls due one month after the settlement date. However, this may vary based on your mortgage terms. You can check the exact date by contacting your lender.

Usually your settlement agent will meet the seller’s representatives to exchange documents at an agreed place and time. The balance purchase price is paid to the seller. The lender will register a mortgage against your title and give you the funds to purchase the new home.

Once the settlement process is complete, the lender allows you to draw down the loan. The loan amount is debited from your loan account. As soon as the settlement paperwork is sorted, you can collect the keys to your new home and work your way through the moving-in checklist.

How to use the ME Bank reverse mortgage calculator?

You can access the equity in your home to help you fund your needs during your senior years. A ME Bank reverse mortgage allows you to tap into the equity you’ve built up in your home while you continue living in your house. You can also use the funds to pay for your move to a retirement home and repay the loan when you sell the property.

Generally, if you’re 60 years old, you can borrow up to 15 per cent of the property value. If you are older than 75 years, the amount you can access increases to up to 30 per cent. You can use a reverse mortgage calculator to know how much you can borrow.

To take out a ME Bank reverse mortgage, you’ll need to provide information like your age, type of property – house or an apartment, postcode, and the estimated market value of the property. The loan to value ratio (LVR) is calculated based on your age and the property’s value.