Interest only lending – the good, the bad and the ugly (Part Two)
Lenders were scrambling over each other to get their business.
Times for borrowers were good, with competition aplenty in the banking marketplace.
Alas, times have changed – but that doesn’t mean that the banks don’t want to lend you money. That is their business after all.
It just means that you have to have your financial ducks in a row – especially around interest-only lending.
You see, the majority of the lending restrictions currently in play are around investor lending, and interest-only loans in particular.
The government regulator, APRA, is worried about the high number of investors in the market, as well as their propensity for interest-only loans.
Now whether this worry is justified is a blog for another day. I’d rather take a look at why the regulators think interest-only lending can be problematic.
So, in this second part of my special three-part series, let’s consider how interest-only lending can be bad.
Borrowers can be complacent with the low cash flow requirements
Do you know the difference between interest-only and principal and interest (P&I) loan repayments?
Let’s use an example of a $500,000 loan at an interest rate of 5.24 per cent to answer that question, shall we?
The monthly repayment for a $500,000 P&I loan over 30 years would be $2,757.92, whereas the monthly interest-only repayment would be $2,183.33.
So the difference between these two mortgage repayments is about $570 per month. And this is really even more dramatic in the current times where a principal and interest loan will be between half to three quarters of a percentage point (0.5-0.75%) cheaper than the interest-only equivalent, thereby narrowing this gap even more.
One of the reasons why interest-only can seem bad is that borrowers can become complacent about their cash flow.
Because they’re only paying the loan interest each month their repayments are lower, and therefore their cash flow is higher, but….
What happens when your interest-only period expires?
Many interest-only borrowers are currently coming to the end of their terms, and lenders aren’t overly keen for them to approve another interest-only loan period.
What does that mean?
Well, it means that that $570 per month they thought they had as spare cash (or cash flow) every month will now be required for mortgage repayments, because their loan has become P&I.
While most prudent borrowers will probably be able to wear this higher repayment requirement, that may not be the case for investors who own multiple properties.
For example, say, John and Judy refinanced four investment properties, five years ago, to the same lender. Those loans were all interest-only but the new lending landscape means they must now move to P&I.
Using the above example again, that may mean that they will need to come up with an additional $2,000-plus a month (or four lots of $570) to meet their new mortgage repayments. How many people have $2,000 “spare” every month?
Of course with professional assistance, John and Judy would be able to negotiate with their lender, or refinance to another one who is more attuned to their financial hopes and dreams.
It’s still a scenario worth pondering though, isn’t it?
Interest-only loans can be far more expensive
Another reason why interest-only loans can be classified as “bad” is that you are not paying off any of the principal.
Now for some investors this is a valid strategy for cash flow and tax efficiency reasons.
But at some point in time the loan principal will need to be paid off.
The ways that this can be achieved are numerous, and include selling the property, selling other property to pay off that property, or paying it off yourself over the life of the loan.
If you were to pay interest-only, however, it would also end up being far more expensive over the life of the loan.
How much more expensive?
Well with our $500,000 example, if you only paid the interest over the life of a 30 year-loan, it will cost you a staggering $786,000 in interest – and you’d still have to pay off the original loan amount of half a million dollars.
However if you made principal and interest repayments over the same period, the interest component would be $492,852.08 – a saving of nearly $300,000!
There is a concentrated focus on interest-only loans, but that’s doesn’t mean they’re not still available, or that they can’t be used effectively to grow your wealth.
The world of banking and finance can be a pretty daunting one for both novice and sophisticated investors, and since our establishment in 2002 we’ve focused on providing outstanding service and business standards.
This approach was vindicated when we were named Victoria’s favourite mortgage broker at the Investors Choice Awards.
So, if want to learn how to make the most of interest-only loan products, why not contact Intuitive Finance today to ensure you have the right information and expert support on your side from the very beginning.
You can read the first part in my series on interest-only loans here.
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The information provided in this article is general in nature and does not constitute personal financial advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information with regard to your objectives, financial situation and needs.