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.