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Do You Have An Interest-Only Mortgage?

Is it time to rethink your interest-only mortgage? Amy Hamilton Chadwick investigates.

12 October 2021

When you make a repayment on your mortgage, you’ll notice the money leaves your account in two chunks: one is principal and other the interest.

The principal is the money that reduces your loan. The interest is what you’re charged by your lender for borrowing the money.

That type of loan is called a principal-and-interest loan. Every repayment, your loan gets a bit smaller. With an interest-only loan, on the other hand, your loan stays the same size. You don’t pay off any principal, only the interest part of the payment.

Short-term win, or a strategy?

You choose interest-only because it reduces your outgoings in the short term – your repayments are lower. There are two main uses for interest-only lending:

1. Homeowners who need help with their cashflow because of a major change, like having a baby or going overseas for several months. An interest-only loan is a temporary measure to help reduce outgoings.

2. Investors who use interest-only loans to buy rental properties. The interest-only loan makes it cheaper to own the properties and investors can funnel any gains back into the repayment of their own home loans.

45pc of lending is interest-only

Around 15 per cent of owner-occupier lending and 42 per cent of rental property lending is on an interest-only basis according to the Reserve Bank. It’s worth noting that it’s 15 per cent of the dollar value, not 15 per cent of homeowners.

Also, some of that homeowner lending will be for investment properties. Buying a house using interest-only lending is not an option, says Joel Oliver, managing director and RFA at SuperCity Mortgages.

“Banks would get suspicious if you applied for interest-only right off the bat as a homeowner. They wouldn’t lend you the money in the first place.

“It’s only for six to 12 months as cash flow relief – and generally only if your loan-to-value ratio is below 80 per cent. Overall, it’s quite a small group of people.”

Investors make up most of those on interest-only loans. Whether or not interest-only makes sense will depend on your investment strategy – if it frees up cash to allow you to repay your own mortgage, it’s potentially a smart idea (get personalised advice).

When should you go back to paying principal?

“For owner-occupiers, go back to paying principal and interest as soon as possible,” Oliver says. “For investors, if you can afford to pay principal and interest and it’s in line with your goals, it’s definitely better to pay down the debt.”

If you’re an investor, you’ll usually get five years interest-only lending at a time, then you need to reapply for another five years.

Right now, the market’s flat and interest rates are low, so investors are consolidating their positions. Switching to principal repayments will increase your equity, reduce your loan-to-value ratio and potentially save you money in the long run.

Some never pay off principal

Oliver says there are investors who never switch to paying principal and interest. They’ll refinance a 30-year loan every five years, adding another five years to the repayment date.

“Yes, they’re ultimately paying more interest, but they’re weighing up the benefits of capital gains and inflation – a $300,000 loan is a Big Mac combo in 30 years’ time,” he jokes.

“The investors who are paying principal and interest are comfortably cash-flow rich – they can have a decent lifestyle and chip away at their principal.”

Fix or float in mid-2018?

If you come off an interest-only loan or you’re refinancing this winter, Oliver recommends you look at the fixed rates, even if only for a year.

He says: “Floating rates are not looking like great value – rates have dropped a little bit and you can fix for one year at 4.15%.”

First published 19 July, 2018

Story by Amy Hamilton Chadwick

JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions. This story reflects the views of the contributor only. Content comes from sources that JUNO considers accurate, but we do not guarantee that the content is accurate.

Informed Investor's content comes from sources that Informed Investor magazine considers accurate, but we do not guarantee its accuracy. Charts in Informed Investor are visually indicative, not exact. The content of Informed Investor is intended as general information only, and you use it at your own risk.

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