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The sudden interest in interest-only loans

We put interest-only loans under the spotlight to explain the why, when and how this type of loan can be useful.

You may be aware that interest-only loans came under the scrutiny of banking watchdog APRA early in 2017. In a bid to take the heat out of the property market and protect consumer interests, APRA introduced new limits to the volume of interest-only loans that banks and other lenders can offer.

When the banking regulator starts asking questions about interest-only loans, homeowners should too. Yes, it’s an option that has its place but the key is to know when interest-only is right for you.

How do interest-only loans work?

First up, interest-only isn’t a type of home loan. Rather, it’s a payment option.

Borrowers can choose between principal and interest (P&I) payments, where part of each repayment goes towards paying down the loan balance, or interest-only payments comprised solely of interest charges with no reduction in the loan principal.

Two main benefits of interest-only loans

Interest-only loans offer two key advantages. Firstly, the repayments are lower than for P&I. Secondly, investors can maximise their tax deductions. There’s no need to separate interest costs, which can normally be claimed on tax, from repayments of the loan balance, which typically aren’t tax deductible.

This explains why investors have traditionally favoured interest-only loans, especially those who plan to sell the property for a profit and pay the loan off using the sale proceeds.

Why the clampdown on interest-only loans?

However, in the heated property markets of Sydney and Melbourne, a growing number of home buyers are opting for interest-only loans.

Sure, this can make it more affordable to buy a home. But there are risks. Interest-only loans mean relying solely on rising values to build equity in your home. If the market dips you could face negative equity – where you owe more on your property than the place is worth. The other risk is you are never really paying off that debt. And for homeowners, aiming to own your place debt-free at some stage – preferably before retirement, is a worthwhile ambition.

Rather than lamenting the clampdown on interest-only loans, a better option may be to explore other loan features that can help you pay down the loan sooner and save on interest charges.

An offset account, for instance, is a handy tool to put spare cash to work reducing interest costs. Or, if a rate rise could bring on a cash squeeze, consider fixing the rate your home loan rate.

Interest-only lasts for a limited time

Whatever your circumstances, bear in mind that lenders usually permit interest-only payments for a limited time − typically up to five years. After this, you’ll likely have to reapply to continue with interest-only payments or revert to P&I repayments.

The key takeaway is that interest-only loans may be suitable if you are buying an investment property. But if you plan to own your place mortgage-free at some stage, steadily paying off a home loan with principal and interest repayments makes good financial sense.

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