Interest-only versus principal-and-interest: why it’s time to revisit the debate

The landscape has shifted in that perennial debate – interest-only versus principal-and-interest loans.

Until quite recently, as much as 40% of all residential mortgages were interest-only – a figure that’s high by international and historical standards.

Both Aussie investors & home owners have been enthusiastically adopting interest-only loans in order to take advantage of well-documented lower initial repayments, tax benefits and greater flexibility.

But while some of these potential perks remain, a number of factors are now coinciding to make it a potential good time to consider the principal-and-interest option.

Is it time to reconsider? First, Let’s have a look at what’s changed

– Tightened lending criteria

Regulators have recently put the brakes on interest-only loans.

In March, APRA said that with such a high percentage of interest-only residential mortgages, it was worried about vulnerabilities to payment shock, interest rate increases and house price falls.

To mitigate the risk, it told lenders to cap interest-only lending at 30% of total new residential mortgages, and to tighten some lending criteria.

So what does that mean for you? Well, it’s getting more expensive and complex to secure an interest-only loan (although, there are still plenty of ways to do so).

– Interest rates 

Interest-only rates are also rising as a result of regulatory pressure to get below that 30% cap – in some cases as much as 100 basis points in the past year.

Meanwhile, rates on principal-and-interest loans have fallen to some extent as lenders have moved to make them more appealing.

In a nutshell? Interest-only rates are going up. Principal-and-interest rates are going down.

So if you’re going to switch, now may be an opportune time to do so, because once lenders start getting more people on principal-and-interest loans they might not feel so generous.

– Flexibility

In the past, one of the major attractions of interest-only loans was flexibility. They allowed investors to borrow more and expand their portfolio.

In many cases, investors have relied on the capital gain from the sale of their property to pay back their principal.

But with tightening around borrowing capacity, some investors may find they no longer qualify to extend their interest-only loan in line with their original plan.

The benefits of shifting to principal-and-interest

Ok, let’s take a quick look a little hypothetical scenario.

Say you take a $500,000 loan. At an interest-only rate of 5.20% your monthly repayments will be $2,167.

It will cost you an extra $235 per month to make principal-and-interest repayments (taking your monthly repayments to $2,402, assuming a rate of 4.05%).

For that extra $235, however, you’re paying $715 off your principal due to the lower rate. You are effectively saving $479 worth of interest each month. Over 30 years that equates to $172,440.

That’s a pretty good return for your dollar. But the benefits don’t stop there.

By saving on all that interest, you’re ensuring more of your money ends up in the equity of the property, rather than the bank’s back pocket.

Additionally, by switching to principal-and-interest, you’re are somewhat protected against a dramatic increase in repayments down the line when your loan does revert to Principal and Interest.

Are there any downsides?

Before you take the leap, however, there are some factors you will need to consider, including:

– Higher monthly repayments

A principal-and-interest loan is likely to cost you more each month, from a cashflow perspective. This may not suit you and affect your ability to manage and grow your portfolio as you choose.

– Reduced flexibility

If you have an aggressive investment strategy you may want to keep cash readily accessible for other investment opportunities that come along.

You may also prefer the benefits offered by an offset account, including the ability to reduce your monthly repayments and minimise tax.

It’s also really important to discuss any future implications of making the switch, because reverting back to interest-only may not be so straight-forward.

So, is it worth it?

Whether or not you make the switch could be one of the biggest financial decisions you make.

Just remember, the above hypothetical is just one scenario and everybody’s situation are different.

So let us run you through your unique situation, help you crunch the numbers, and draw on all the very best resources to help you make an informed decision.