Interest only loans – what does it all mean?

Over the past twelve months the Australian Prudential Regulation Authority (APRA) has been cracking down on interest only lending.

APRA has put a limit on interest-only lending to 30 per cent of total new residential mortgage lending, put restrictions on interest-only lending on loan to value ratios above 80 per cent, and asked for strong scrutiny of interest-only loans at an LVR above 90 per cent.

A recent survey of a panel of economists by comparison website Finder found more than half thought those switching from interest-only to principal and interest may face difficulties refinancing.

What is an interest-only loan?

An interest-only loan in the residential housing context is a type of mortgage where the home owner makes repayments on only the interest portion of the loan.

That is, they don’t pay down the “principal” component of the loan – the part that actually pays off what the asset is worth.

By comparison, in principal-and-interest loans the borrower repays both of these components. This is usually the more common type of loan, particularly among owner-occupiers, and it means that you are continually paying down the actual worth of the home.

Why would someone want an interest-only loan?

An interest-only loan has much lower repayments than a standard loan, and this can be attractive for many reasons. It doesn’t cost the property owner as much to pay their mortgage – making it easier to hold.

For investors, this means they might have a higher cash flow – or be less out of pocket. And for home owners, this can be a way to free up funds for other ventures. The interest portion on an investment loan is often tax deductible while the principal portion is not.

Those who have plans to sell the home in the short-to-medium term and are anticipating substantial capital gains could find this attractive.

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