WHAT YOU NEED TO KNOW ABOUT INTEREST ONLY LOANS

An “Interest only loan” is a mortgage where the amount of the loan, known as the principal, is never reduced – the borrower only pays the interest on the amount borrowed.

This means if a person borrowed $500,000 as an interest only loan, the borrower only has to pay the monthly repayments to cover the interest on the amount borrowed.

For example, after five years, the borrower would have paid interest on the loan but the amount of the loan still outstanding would still  be $500,000 because none of the “principal" had been paid off so the loan wasn’t reduced from the original amount of $500,000.

An interest only loan is in direct contrast with the usual “Principal and Interest” loan where the monthly repayments pays both the interest and part of the principal.

This means that after 5 years, the amount of the loan outstanding would have been reduced so also reducing the amount of interest that has to be paid as the loan amount is reduced.

In the 1970’s, interest only loans were popular with both banks and borrowers because property values always seemed to go up so if borrowers did want to sell their property after 5 years, the amount borrowed would not have changed, but the property value would had gone up, so the borrower had made a capital gain without paying off any of the principal.

This all changed in the 1980’s when interest rates rose to 18% and property values went flat.

Today, it appears mainly property investors seem to obtain interest only loans and even then the length of the term can be restricted to no more than 5 years.

However, the investor segment of the property market is growing and interest only loans are growing by 20% a year.

For investors with an interest only loan there are a few inherent problems that may occur during the life of the loan and beyond;-

1. When the interest only period ends after 5 years, what does the barrow do then? Find another bank that can offer an interest only loan?
2. Stay with the current lender and pay higher repayments to cover the interest and principal repayments which may not be able to be serviced from the investment property's income?
3. Sell the property, but it may be the wrong time to sell and the property value could have reduced below the amount of the loan outstanding?
4. Unless the borrower has a fix interest only loan, the interest can go up during the period of the loan so causing financial stress if the income from the investment property doesn’t cover the amount of the repayments.

When considering an interest only loan, the borrower needs to consider what may happen during the life of the loan and in particularly when the interest only period expires.