Interest Only Home Loans

Interest Only (IO) loans have always been popular with investors but had become increasingly popular with owner-occupiers as well.

In fact, so much so that there has been significant Regulatory intervention by both ASIC (the Australian Securities and Investments Commission) and APRA (the Australian Prudential Regulation Authority).

The Regulatory position adopted by most Lenders is now that an IO loan can only be obtained for an owner-occupied property if there are compelling reasons to do so. 

Some Lenders will simply not offer an IO loan to an owner-occupier under any circumstances.

At the same time the available Loan to Value Ratios (LVR) have been decreased for IO loans while the interest rates have increased. 

Rate increases have been applied to both owner-occupied IO loans and investment IO loans.


BACKGROUND


Investors have traditionally favoured IO loans as this maximises their tax deduction on interest while minimising their outgoing cash flow because they are not making any principal repayments.

However, IO loans were also used by some Lenders and mortgage brokers (quite incorrectly and in breach of Responsible Lending obligations) to increase a customer’s borrowing capacity by only taking the actual monthly interest repayments into account and ignoring the much higher P&I repayments at the end of the IO period.

It was this phenomenon (coupled with the appeal of offset accounts) that was causing many owner-occupiers to also opt for IO loans.

And it was this phenomenon that caught the eye of the Regulators.

Now the servicing (borrowing capacity) position for IO loans has been flipped on its head (or more accurately – it has been corrected). 

Not only are IO loans now assessed based on the P&I repayments following the IO term, but they are also assessed on the remaining P&I period.

So, for a 30-year loan with an initial 5-year IO period, servicing will be conducted on the remaining 25-year P&I loan and therefore produce a lower borrowing capacity than if the loan was P&I for the full 30-year term.


URBAN MYTHS


So, the 1st urban myth that we want to dispel is that IO loans improve your servicing outcome as outlined above.

The 2nd urban myth that still seems deeply entrenched is that IO loans cost you less.  This myth is based on the fact that the minimum monthly payment for an IO loan will always be less than the P&I payment for the same loan amount.

But that doesn’t mean the loan is costing you less.  Principal must always be repaid at some point and is not part of the cost of a loan.  Put simply, the cost of a loan is the total of interest, fees and charges.

Therefore, an IO loan will always cost you more – as you are paying interest on the full loan amount for longer.  Add to this the fact that interest rates for IO loans are now higher and an IO loan will always cost considerably more.


OUR VIEW OF THE CURRENT POSITION


IO loans for investment debt


Increased interest rates for IO loans may undermine your after-tax benefit when compared to a lower cost P&I loan.  So do the maths.

However, IO loans for investment still largely make sense if the increased rate is not too significant (it shouldn’t be if you shop around) and assuming that you also have non-deductible debt elsewhere

But if you have no other non-deductible debt then paying a higher interest rate and more in total interest just to get a higher tax deduction is just plain stupid (sorry).

N.B.  This is not tax advice – its just simple maths. 

Depending on your marginal tax rate you will spend a dollar in order to save 30, 40, or 48 cents on tax.  In other words, you will be losing at least 52 cents on every dollar of interest.

With the greatest of respect to Accountants who may give advice to maximise tax deductions – you need to be aware that “he who is good with a hammer sees everything as a nail”. 

A tax deduction where the expense is justified on its own merits is a wonderful thing – but spending a dollar to save 40 cents is bad use of your money.

IO loans for personal debt


Regardless of the individual credit policies of each Lender, we contend that IO loans for non-deductible debt (i.e. your own home) are largely taboo.

There are, of course, always exceptions to the rule.  These exceptions are usually based around short term requirements for reduced cash outgoings (e.g. planning for a new child, an income earner is taking long service leave at half pay etc) or because the nature of the property (and debt) is going to change to an investment in the short term.

However, requesting an IO loan purely on an affordability basis – i.e. you feel that P&I repayments would create financial stress - must be viewed as a prima facie reason to decline a loan, not approve it.

Even where you have a valid reason for an IO loan please note that you will still need to prove your servicing capacity based on the remaining P&I loan term.


CONCLUSION


As with many of our Fact Sheets, we want to assure you that we have no bias – in this case around the use of an IO loan facility. 

We simply want to make sure that you understand the considerations involved and only opt for a more expensive IO loan when your circumstances clearly dictate that it makes sense and meets responsible lending guidelines.

If you’re unsure – please feel free to Contact Us.


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If you have been directed to this Fact Sheet by your Independent Mortgage Planner it is in order to allow you to review some relatively detailed considerations in your own time and at your own pace. Only any specific advice subsequently, or previously, provided by your Independent Mortgage Planner constitutes personal advice.  In all other circumstances, the information provided in this Fact Sheet is general in nature only and does not constitute personal advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information in this Fact Sheet you should consider the appropriateness of the information having regard to your objectives, financial situation and needs. Before making any decision, it is important for you to consider these matters and to speak to an Independent Mortgage Planner. We provide Credit Advice only. You may also wish to seek appropriate legal, tax, and other professional advice.

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