After regulation some years ago capping Interest Only lending, growth in that category has moderated. So is there still a place for Interest Only lending?
Data from the banking and insurance regulator, Australian Prudential Regulation Authority (APRA), shows interest only loans represent less than 20% of all new mortgage lending. This compares with close to 40% in the years prior to regulation.
Over recent years, we have seen interest rates on Principal & Interest ("P&I") lending fall (both for investment, business and personal purposes) much more significantly than interest only lending. In addition, financial institutions have become increasingly stringent on justifying reasons for allowing interest only basis of loan repayments.
So what does this mean for you?
PRINCIPAL & INTEREST REPAYMENTS (P&I)
P&I will mean greater cash outflow, as the loan will "amortise" from the outset.
There is a material benefit with the interest rates on P&I repayments will become increasingly lower than interest only loans, even if this trend has reversed a little during the past year.
Consider the following example on a $500,000 loan:
At 5.0% Interest Only - Repayments are $2,083 per month.
At 5.0% P&I - Repayments would be $2,684 per month.
This is a substantial increase to cash outflow but it does build some equity in this asset too.
Now add in benefits of a reduced interest rate of 4.00%.
At 4.00% P&I repayments would be $2,387 per month.
This is only a small premium above the interest only basis of repayment.
YOUR OPPORTUNITY COST
For business or investors, those in the position to choose between interest only and P&I must consider their opportunity cost. This is especially true in a low interest cost environment.
So, in the example above, is it better to invest the additional $304 per month into the debt, or can you get a better return by conserving this cashflow and putting it to work elsewhere?
People will often talk about negative gearing in this context; however, for negative gearing to work, you need a consistent cash flow to cover pre-tax losses.
MATCHING BENEFITS WITH LOAN TERM
Businesses and individuals borrow for a variety of purposes. For assets that have a limited useful life or benefit, the basis of repayment should also be based on a loan term that matches the period for which a benefit (say income) is generated.
Seek advice of course, but consider why you actually need interest only repayments.
It is a great opportunity to litmus test your overall investment strategy.
More information?
Contact MCP:
E - mcpnews@mcpgroup.com.au
W -www.mcpfinancial.com.au
T - (03) 9620 2001
The team at MCP Financial Services has specialised expertise in advising and structuring Mortgage Lending.