Home loans don’t need to be complex, but it’s important to understand your options when it comes to your repayments.

WHAT’S THE DIFFERENCE BETWEEN INTEREST-ONLY AND PRINCIPAL AND INTEREST LOANS?

 

Interest-only loans comprise only of interest repayments, without any repayment of the principal (the amount you borrowed). Interest-only loans typically have a maximum period of 5 years, after which the loan reverts to normal principal and interest repayments.

When the loan converts to principal and interest, the repayments usually increase as you begin to make repayments of the amount you borrowed in addition to the interest for the period. This in turns affects the affordability of the loan.

Borrowers should exercise caution in choosing an interest-only loan given the potential implications on affordability and risk of not being able to make repayments in future. Further considerations to monetary policy and regulatory changes must also be taken into account. It is commonplace to see interest-only loans used for investment property purchases or forming a part of a strategy to purchase your next home.

Loan structures are most effective with advice, tax planning, and consideration to your longer-term financial objectives and position.

THE PROS & CONS OF INTEREST-ONLY LOANS

Interest-only loans are attractive for several reasons. However, it is important to consider the pros and cons and what it could mean for you before making a decision.

Benefits:

  • Lower monthly repayments – Since you are not paying the principal, your repayments will be comparatively lower.
  • Greater tax deductions for investor loans – The interest paid on a loan used for investment purposes are tax deductible. If you are not reducing the principal balance of the loan, investors are able to claim the maximum tax deduction. Paying off the principal means interest would be calculated on a smaller loan amount which reduces the tax-deductible amount.
  • Extra cash flow to invest elsewhere – Since you are only making the minimum interest-only repayments, you can direct your extra cash flow (which would otherwise go to reducing the principal) into paying off your home loan.

Disadvantages:

  • Higher interest rates – Due to pressure from the Australian Prudential Regulation Authority (APRA), lenders have increased the cost of holding interest-only loans. That is, a higher interest rate for interest-only loans are likely to apply.
  • Putting off the inevitable – The loan will eventually need to be repaid. Without making any repayments of the principal during the interest-only term, you may be paying more interest over time.

If you are considering an interest-only loan, a solid strategy for when and how the loan will be repaid and where you intend to invest your surplus cash flow should form a part of your considerations.

Speak to your Home Loan adviser or contact us to find out how best to structure your loan.

This advice is general and does not take into account your objectives, financial situation or needs. You should consider whether the advice is suitable for you and your personal circumstances.