Interest-Only VS Principal and Interest Mortgage Repayment
Updated: Mar 10
Australian bank loans generally have two repayment methods:
1. Principal and interest
2. Interest only.
What is the difference between the two? This starts with the evolution of the mortgage interest rate policy. In the past, interest rates were the same for all types of home loan products, whether principal and interest only, owner-occupied housing or investment housing. However, later APRA made two major changes to investor and interest-only loans.
1. Benchmarks for investor loans:
Beginning in December 2014, APRA announced restrictions on home investors, and introduced a 10% annual growth rate limit to investment mortgages. Subsequently, banks have slowed the investment rate of investment mortgages. Banks usually resort to measures such as raising interest rates on investment products, tightening mortgage policies, and some banks stop lending to investors altogether.
In April 2018, APRA announced that the 10% benchmark would be removed due to the difficulty of implementing this benchmark, particularly for small lenders, and a weak market during that time.
2. Benchmarks for interest-only lending
In early 2017, 40% of home loans were interest-only. However, due to high housing prices, slow income growth, and possible future interest growth, regulators worry that lenders will accumulate more debt and face a “repayment shock” after the 5–10 year interest-only period ends.
As a result, in March 2017, APRA adjusted its mortgage policy again, limiting interest-only loans to 30% of total housing loans, and increasing interest rates on bank restricted interest-only products and interest-only loans. In September 2017, the ratio of interest-only loans to total loans remained stable at around 20%.
In December 2018, APRA said it had achieved its goal of reducing interest-only loans, announcing the elimination of benchmarks for interest-only lending, with more competitive interest-only loan products gradually emerging on the market.
Homebuyers are often hesitant to choose between the two options. Should you choose interest-only or principal and interest?
What is interest-only repayment?
As the name suggests, interest-only repayments refer to repaying only the interest portion of the loan within the selected period (usually 5 years), thereby reducing the minimum repayment amount.
In other words, the borrower can choose to repay only the interest and not the principal in the first 5 years and start the normal repayment of interest and principal after 5 years.
In practice, for borrowers who want to continue to use interest-only repayments, they can re-loan after the 5-year term, and the term is recalculated to 30 years.
Advantages of interest-only payments:
1. The interest-only repayment model makes the weekly repayment amount slightly lower, thus increasing the cashflow in the lender’s hand, and the expenditure incurred in the investment is relatively low. Therefore, many home buyers for investment purposes tend to choose to only pay interest.
2. Australia can be negatively geared. If the house is used as an investment, repaying only interest can maximise the lender’s book loss, thereby achieving the purpose of tax deduction.
3. Interest-only products can usually be used in conjunction with hedging accounts, which can maximise the liberalisation of idle funds and reduce the cost of housing maintenance.
Risks of interest-only payments:
Although interest-only repayments have certain advantages, there are also corresponding risks.
1. At present, the loan products on the market generally have high interest-only interest rates, usually about 0.5% higher than principal and interest rates. In the long run, the interest-only repayment will be much higher than the total amount of interest accrued with interest and principal.
2. If this method is adopted, the initial monthly payment will be low, which will reduce the repayment pressure to a certain extent. But once interest rates rise or one’s own financial situation changes, the financial burden on households will jump.
3. If the lender has poor capital management ability and does not have good consumption habits, choosing to only repay interest may cause the borrower to increase in a lot of extra expenses.
When choosing an interest-only repayment loan product, the borrower should clearly understand that the loan principal will not be reduced, the interest expense will be higher, and the income affordability will be correspondingly low. Additionally, monthly repayments will increase significantly after the interest-only loan contract ends.
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