Interest-only loan expiration: what happens next?

An interest-only loan allows you to pay just the interest component of your home loan while leaving the principal untouched, which essentially means lower monthly repayments.

Depending on your loan, interest-only (IO) products are only available for a short term, typically five years. Interest-only loans are popular with investors for tax purposes, first home buyers trying to make their loan repayments more affordable after the initial upfront expense of buying, or buyers who only plan on holding onto a property for a short period of time before selling it. While there are short-term benefits for certain people with IO loans, they are not suitable for everyone.

One of the pitfalls of an interest only loan is that property owners aren’t paying down the principal to reduce their debt or building up any equity in their property. For investors, though, this often isn’t a concern. They may be looking to sell the house for a capital gain before the end of their home loan term.

A hefty impact on many home owners is when an IO loan term expires. The IO home loan will automatically revert to P&I, this means that home loan repayments can rise significantly and come as a shock to the household’s available cash flow. In the current market, home loan interest rates are comparatively low, so paying principal and interest will allow you to pay down the principal loan amount, so when the inevitable happens and rates increase, you will be paying higher rates on a reduced loan size.

The calculations below show just how significant a jump this can be:

Scenario 1: IO Scenario 2: P&I
Loan term 30 years 30 years
Loan amount $700,000 $700,000
Interest rate 5.24% 4.74%
Repayment frequency Monthly Monthly
Repayment type Interest Only Principal and interest
Monthly repayments $3,057.00 $3,648.00

As you can see above, this amounts to an additional $591.00 per month, or $7,092.00 per year.

If you haven’t budgeted for this change, it could be quite a financial shock when your loan reverts to P&I. Whether or not you choose to, or are able, to extend the interest-only period on your loan, knowing when your home loan is due to revert to P&I repayments can help you budget and be financially prepared for the change.

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