Australia’s property market may be slowing but after years of record house prices, the size of the average home loan remains at record levels.
It’s no wonder, then, that more and more Australian home owners are turning to interest-only home loans – traditionally an option favoured by investors taking advantage of the tax-deductibility of interest payments on investor loans.
The Reserve Bank of Australia (RBA) highlighted the trend towards interest-only payments in its most recent biannual review of financial stability, and the figures speak for themselves – the proportion of interest-only loans to owner-occupiers has risen from below 15 per cent in 2009 to above 25 per cent today.
At finder.com.au, we’re observing the trend first hand by witnessing a 389 per cent spike in traffic to the interest-only loans page in the 12 months to October 2015.
What’s behind the trend?
The RBA speculates that homebuyers are using interest-only loans ‘as a means of affording a larger loan’.
In other words, as property prices crept higher over the years, homebuyers opted to borrow larger amounts rather than delay their entry into the property market until they had saved a bigger deposit.
An interest-only loan means paying off the interest charged on the loan only and not the capital (the actual amount borrowed), which makes the repayments more affordable.
Other reasons buyers may go down the interest-only route is to be able to use the extra cash on renovations or other major expenses, or because they are expecting a pay rise or a windfall in the near future, at which point they can increase their repayments.
If paying interest only sounds attractive, keep in mind that it is usually for a specified period (typically five years) before you have to start paying off the principal loan.
What’s the catch?
While an interest-only home loan can be seen as a cheaper way to buy a home thanks to the lower repayments, going down this route can be a risky strategy.
Because you’re only paying off the interest, you’re not actually reducing the original amount you borrowed – so it will take you longer to pay off the mortgage and you’ll end up paying a lot more. Paying off your loan as fast as possible – by paying off more of the principal amount – is the best way to save money in the long term.
There is also the danger that paying interest only can lull you into a false sense of security – which is especially dangerous if you’ve used your home loan to consolidate debt –so that when interest rates rise or the loan reverts to principal-and-interest you’ll be stretched to meet the repayments.
Another risk is being left vulnerable in the event of a fall in property prices, which would leave you owing more than the house is worth or at a financial loss if you need to sell. As the RBA noted in its financial stability review: ‘With a principal-and-interest loan, a borrower making scheduled repayments would typically pay off about 10 per cent of the loans principal over the first five years, establishing a buffer against a fall in house prices’.
With interest rates at historical lows, now is the time to make headway on your loan by paying off more of the principal while the repayments are relatively low. That way, if interest rates rise, the increased repayments won’t come as a shock and you’ll be paying off the higher rates on a reduced loan size.