As you may have seen in the media, APRA has recently announced tougher measures to limit interest only lending in a bid to slow down the investment market and property values in Sydney and Melbourne.
Currently 40% of new mortgages are interest only loans, which APRA wants to see reduced to 30%. The measures taken to reach this goal include –
- making it more difficult for customers borrowing above 80% of the loan to value ratio to gain access to interest only lending,
- raising the cost of interest only lending
- reducing borrowing capacity by instituting tougher serviceability metrics.
If you have an interest only loan, you may have already noticed an increase in interest rates. Given the current climate, now is a good time to revisit why you may have chosen an interest only loan. Below we have outlined a balanced view of three of the basic Pro’s & Con’s for selecting interest only loans. There are more layers to be considered in most cases.
- Maximise tax deductions: If you have tax deductible debt you can select interest only to focus on placing all your surplus cash flow towards reducing non-deductible. Similarly, if you have a home that you hope to become an investment property, you may choose to store your surplus cash into an offset account rather than into the loan directly. This can allow you to maximise the deductions when the home becomes an investment, and your savings can go towards reducing the debt on your future home.
- Flexible repayments: you are still able to pay down the principle of your loan, either directly into the loan account or via your offset. However, you choose the amount of principle you pay
- Maximise your cash savings: Interest only repayments are lower than principle and interest repayments. This means that you have more surplus money in your pocket each month that you can still place this into your loan or an offset account to reduce your interest in the same way as you are forced to with principal and interest loans. An interest only repayment approach allows you to build cash buffer more rapidly because you still have access to the cash that otherwise would have for the principal component of the repayment. This extra cash availability via redraw or offset can assist with risk management, should you have any unexpected expenses or in the event of reduced income for a period to provide you with extra time to make decisions.
- No forced additional repayments: Without being forced to make additional repayments you may just spend the extra cash that otherwise would have went towards reducing debt.
- Potential for higher principal and interest repayments in the future: The lender policy is tightening up making it more difficult to extend interest only periods. You may also not be able to refinance to another lender. This means there is the possibility that you may have a reduced loan term which has the potential to increase your monthly repayment commitment in the future.
- Higher interest rate: You are now paying a premium for the privilege of the extra flexibility and tax deductions that you receive from the interest only approach.
There is no one size fits all approach to mortgage strategy or property planning decisions. You should determine in conjunction with your trusted adviser the approach that is appropriate based on your goals, risk tolerance and financial situation.
As part of our money management strategy, if you select an interest only loan, we always advocate setting up a direct debt into your loan or into a ‘repayment’ offset account that you do not touch or have ATM access. In effect this allows you to obtain the best of both worlds effectively emulating a principal repayment approach whilst optimising the pros of selecting interest only.
As with all financial decisions a key to success is your money management, irrespective of the repayment approach that you take.
Contact us if you would like to discuss your money management system or the pro’s and con’s to interest only lending V’s principle and interest