What is an interest-only loan?
Interest-only loans have grown considerably in Australia over the past few years. However, a recent crackdown from the Australian Prudential Regulation Authority on this type of lending highlights the risks of these loans to both the lendee and economy.
An interest-only loan is commonly used if you are buying a house or refinancing your current mortgage. These types of loans only cover repayments on interest for the amount borrowed during an interest-only period as opposed to principal and interest loans where the repayments reduce the principal and pay off the interest.
Interest-only loans are appealing to home buyers as there are lower repayments at the start of their loan and they can be used for investing and tax purposes. However, these short-term benefits may not outweigh the long-term costs.
Once the agreed interest-only period is up, the loan reverts to a principal and interest loan – resulting in significantly higher repayments. As the interest-only period only covers the interest, you do not reduce the amount of money you owe during this period; therefore you end up paying more interest over the lifetime of the loan.
Interest-only loans also rely on house prices to rise. These loans carry the risk of leaving the lendee with no equity in their home at the end of the interest-only period if their property does not increase in value during this time.
Before entering into an interest-only loan, you should carefully consider whether you will be able to afford the higher repayments once the interest-only period ends. Comparing interest-only loan repayments to principal and interest repayments will also help you to decide if the short-term benefits are worth it in the long run.