What is an Interest Only Home Loan?
Interest only home loans and their restrictions are in the news a fair bit of late. I believe knowledge is power so here is my 5 minute guide on What is an interest only home loan; what they are, why the interest rate is higher and what to do if you have one?
What is an interest only home loan?
An interest only home loan is where you make repayments each month on your loan to the bank. Your repayment is ONLY the amount of interest you have accrued on that loan in that month. You are not paying anything off the capital.
Example: You purchase a house and take a loan for $500,000. The interest on this loan might be $1500 per month. Your repayment amount is $1500. In 5 years’ time you still owe $500,000 on that loan because you have only been paying the interest. (Note: you are not paying off future interest in advance. You are paying off daily accrued interest for the previous month)
Why would you have an interest only home loan?
The main reason you would take out an interest only home loan would be on an investment property. The reason: you would be looking for the value of the property to go up and the interest you are paying is a tax deduction. You would also be hoping for rent to cover most of the loan.
Example: The house you purchased in the above example is worth $500,000 when you buy it and you sell it in 10 years and it is valued at $800,000. You pay off your interest only loan of $500,000 leaving $300,000 equity. (there may be additional fees and taxes to be paid from this).
Why are the interest only home loan rates higher than Principle and Interest rates?
A government body called APRA (Australian Prudential Regulatory Authority) issues lending guidelines restricting the lending on certain types of loans. The flow on effect of this is that the banks need to comply with APRA’s guidelines which further has the flow on effect of ensuring the movement in the market is aligned with the country’s (government’s) fiscal policy and our banks and lenders do not ‘go under’. Currently APRA has deemed that there are too many interest only home loans on the books, placing the banks at risk.
So how does this (above) work?
Let’s look at how this works. Banks raise rates of interest only home loans in reaction to APRA policy. They do not raise principal and interest (P+I) rates (that is when you pay off the interest AND the capital so your loan balance reduces and eventually you pay your loan off). This means that the consumer (ie: you) is dissuaded from taking an interest only loan and encouraged to look at alternatives (such as P+I). In the big scenario and at a very generalised high level summary what this means is that the banks (because of government regulations) will get you to reduce your debt and the banks will be in compliance with APRA policy.
An example would be if a house was purchased for $500,000. You pay interest only, but house prices fell and now the house is only worth $450,000. This places the bank at risk. The bank will want you to pay off some of that debt to reduce that risk. By increasing interest only home loan rates, it makes it more inviting for you to go to a principal and interest loan. APRA looks at all the country’s debt as a whole and puts policy in place to keep things afloat.
I have an interest only home loan and I want to know my options – what do I do?
You can talk to your current lender about switching to Principal and Interest. Dennis Smallwood can do this on your behalf. We are debt reduction specialists.
If you have an investment property and an owner-occupied property (your own house) you may even want to look at the structure of these debts overall. A restructure could be beneficial to you.
Reach out to me via phone or email if you would like to discuss this in a more private forum.
The Home Loan Comparison Co. compares home loans from a much wider variety of banks than most people have time to consider, and we find the loan that suits your goals.
We are experienced, knowledgeable and dedicated to building ongoing relationships to keep on providing personal and valuable service that is rarely experienced when dealing with the banks.