What to do when your interest-only loan is expiring

Interest-only loans can be hugely advantageous for some borrowers, but anyone who has one needs to understand their long-term effects, particularly as the initial interest-only period reaches its end.

During the interest-only period, the principal amount you have borrowed will not reduce. The upside, however, is that your mortgage repayments are lower than if you were paying back both principal and interest.

Interest-only loans are favoured by many investors. The strategy goes that although the principal is not reducing, the value of your property is rising. Because the repayments are lower, you can afford to borrow more capital and invest additional funds in growth assets.

Say you borrow at a 95 per cent LVR to buy a $500,000 growth asset (so, a loan of $475,000) and the property sees six per cent annual capital gain. 

You borrow with an initial interest-only period of five years to keep repayments to a minimum. At the end of that five years, you still owe $475,000 of principal, but your asset’s value has grown to approximately $670,000. So, you’ve kept your monthly mortgage repayment low while enjoying a $170,000 uptick in your net equity.

Well, if you do nothing, they automatically revert to Principal + Interest (P+I) loan repayments which are dramatically higher.

Let’s assume you borrow $750,000 at five per cent annual interest on a 25-year loan. If you did this purely as a P+I loan right from the start, your repayment would be $4384 per month.

Now, let’s nominate a five-year interest-only period at the start of that loan which is charged at 5.2 per cent annual interest (the interest-only rate is normally slightly higher than the P+I rate). During that interest-only period, your monthly repayment will be $3250.

When the five-year interest-only period ends, you will still have a total loan of $750,000 but will now have to pay that back in 20 years, not 25. Assuming all else remains equal (i.e. your P+I interest rate remain at five per cent), the repayments under this reduced 20-year timeframe rise to $4950 per month.

So, five years after you start the loan, your monthly mortgage repayments will automatically increase by $1700 per month above the interest-only repayments.

Also, if you’d paid P+I from the start of the loan, you’d have been up for $4384 per month. Now, you’re required to pay $4950 per month – or $566 more per month for the remainder of the loan period.

While you have been enjoying the benefits of capital growth and increased household cashflow during the interest-only stage, when it ends these higher repayment amounts can take a hefty toll on your home finances.

The answer is yes, you can extend your interest-only period, however there are considerations you must weigh up.

Firstly, extending your interest-only period could trigger a full loan reapplication.

In some circumstances, a conversation with your lender might be all that’s needed, but that would be rare at present with interest rates having risen so much already.

Next, extending your interest-only period adds further to the interest bill across the life of the loan, because you’ve deferred paying back any of the principal.

If you are an investor with multiple loans, you should also factor in the impact an interest-only loan will have on other loans you plan to apply for. This is because lenders will calculate your loan serviceability based on the mortgage repayments you’ll be making AFTER your interest-only period ends.

As you can see from our earlier example, that can be a huge hit to your available cashflow.

So don’t be flippant about extending an interest-only period – it will have implications down the line.

A mortgage broker can look at your financial situation and provide an overview of options based on your circumstances. For example, they’ll highlight the strengths and challenges surrounding a potential loan reapplication.

They can also discuss the variety of lenders who could assist. It may be the case that refinancing the whole loan with a different lender offering more favourable terms could be the best way to proceed. Alternatively, they may find a financier with better interest-only options. Apart from the interest rate, you may benefit from additional loan features such as an offset account, lower fees or a no-penalty early repayment.

Whatever the challenge, a mortgage broker should be your go-to guide.

The main thing, however, is to ensure you seek their help early. Don’t delay until the interest-only end date looms. Instead, allow plenty of time to thoroughly research the options so you can make a fully informed and highly beneficial choice.