Why you should be careful with interest-only loans

AMID the credit crunch that is dragging on house prices, it is tempting for borrowers to seek out interest-only loans to minimise their repayments and maximise the amount of capital they can access.

Professional advice is essential before deciding whether to take on such a loan, or opt for the traditional structure in which the principal and interest – known as “P&I repayments” – are paid.

Loans that permit interest-only payments for an initial period, say five years, can end up being more expensive, hitting the household budget severely.

Monthly repayments jump significantly when the interest-only period expires and the principal must start to be paid off.

Here’s an example: for a 25-year loan with five-year period of interest-only repayments, the lender will calculate the repayment period of the principal across 20 years. This significantly raises the required repayment on a monthly or fortnightly basis.

If that new sum is more than a borrower can afford, a bank may not continue with the loan for any number of reasons. This can include a fall in the value of the relevant property against which the loan is made.

The borrower may have to refinance the loan, which can be expensive, seek a new lender or, in the worst circumstances, default on the loan and lose their home.

The difference in monthly totals, especially if the loan is for more than $1 million, can amount to well in excess of $1,000. The only partial relief might be if the borrower was paying a higher than standard rate to obtain an interest-free loan.

Tips to avoid this trap

  • If you are paying interest-only now and are unsure of the repayments schedule when the principal must be paid, then obtain clarity and advice from the lender immediately
  • Ask the lender if you can put any savings or additional capital against the loan before it moves from interest-only to “P&I”
  • Seek independent financial advice based on the lender’s information

This article is of a general nature. Readers should seek professional advice.


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