Managing the transition of your interest-only loan

Nov 16, 2022 | Finance, Home Loan, Interest rates

Just over four years ago Sarah bought an investment property. To help pay for it she took out a $400,000, 25-year mortgage that offered interest-only (IO) repayments for the first five years. At an interest rate of 4% per annum those initial repayments amounted to $1,333 per month.[1]

The benefit of IO was that it offered lower monthly loan repayments for five years, putting less strain on Sarah’s budget. However, with the IO period set to expire and the loan about to convert to principal and interest (P&I), Sarah now faces a significant jump in her monthly repayments. With 20 years remaining on the loan and at a steady 4% interest she now needs to repay $2,424 per month, an increase of $1,091.

Sarah was well aware that this increase was coming, of course, and the higher payments were factored into her budget. Using an IO loan to kick off this investment worked out very well for Sarah.

Unfortunately, the same can’t be said for property investors who used the lower initial repayments on IO loans to borrow more money to buy more property, often at high loan-to-valuation ratios (LVR). After all, property was booming. What could possibly go wrong?

Not so rosy

Well, as it has turned out, quite a bit. Action by the regulators APRA and ASIC to curtail ‘risky’ lending saw a significant drop in the availability of IO loans. This in turn has been a major contributor to the weakening of major property markets, most notably in Sydney and Melbourne. Also having an impact was the increase in interest rates charged by lenders, independently of changes in official rates.

Options

So what might be the options for borrowers who may face difficulties in meeting their increased loan repayments?

  • Dip into savings – if there are any. That’s unlikely to be the case with investors who used lower IO repayments to maximise borrowing rather than banking those savings for later.
  • Sell properties. Some property markets have retained their values, and properties bought before the markets peaked may be worth more now. Realising some equity by selling one or more properties may be a way of reducing financial stress.
  • Extend the length of the mortgage. This may help to reduce P&I repayments, but lenders may be less willing than previously to offer this option.
  • Review loan(s) with a lender or mortgage broker. Better deals may be available, though it’s important to remember to take any switching costs into account.

Another thing to check: if the value of the property has fallen, is the loan now more than 80% of the market value? If so, mortgage insurance may now be payable.

Avoiding the pitfalls

Interest-only loans are still available and any market undergoing a “correction” will generate opportunities as well as challenges. Property investors needn’t flee the market, but do need to plan early and understand the potential risks, including those associated with IO loans, as well as the possible returns.

[1] Figures from MoneySmart interest-only mortgage calculator www.moneysmart.gov.au

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Authorised Credit Representative 383415 of IFBA Pty Ltd.  Australian Credit Licence Number 383415.
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