Interest only loans: what you must know

Interest only (I/O)

For a period of time, usually 5 years, the borrower only has to make interest repayments on the mortgage, and does not need to pay back any of the money borrowed during that time. Many if not most investors do this for all their investment properties to aid them in building a portfolio.

It assists first homebuyers with cash flow on their home, as it reduces their repayments, helping them deal with the cost of furniture, and moving. It provides more surplus for would be investors, therefore possible making it easier to afford to hold a negatively geared property.

Lenders used to assess interest only repayments in their serviceability calculators but this has changed for most lenders, most now service all existing debt as they do new debt, at a qualifying rate of above 7%, usually 7.2%-7.4%, with Genworth, one of the mortgage insurers has been using a qualifying rate of 8%, even though the repayments may be below 5%, on your loan.

In relation to a banks servicing calculator, your borrowing capacity will be reduced, depending on the lender chosen, if you elect for an I/O period, as the lenders will factor in the fact you will have to repay the entire loan in only 25 years not 30 years (based on 5 years interest only period) this places pressure on servicing and can reduce your borrowing capacity.

Borrowers do risk being caught off guard if the have too many loans, particularly for their circumstances, set up as interest only. When the loan (s) do convert to P & I the repayments will jump up considerably for two reasons.

  1. Previously the borrower was only making interest only repayments on the debt, now they are paying back the debt in increments as well as still paying interest.
  2. The increments of debt now being paid back are condensed into the remaining life of the loan of say 20-25 years (the remaining life of the original 30 year loan), this makes the increment of debt each week or fortnight or month much higher than if a P and I loan was taken out to begin with, and spread over the 30 year life of the loan.

Many investors to avoid this higher more condensed repayment schedule, refinance to another lender on a standard 30 year term, sometimes 40 years, just to make it easy to avoid the sudden jump in repayments associated with the more condensed timeframe.

According to ASIC, after they carried out a cost comparison, it was found that could pay $32,000 more in interest repayments if they elected for a 5-year interest only loan compared to a principle and interest loan. Over $80,000 if the interest only period was 10 years.

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