What to do when your interest-only term runs out
If you invest in residential property, you may have decided to lock your loan into an interest-only period. Interest-only terms are popular among residential property investors for several reasons, while interest-only investment loans are a way for landlords to keep costs down and help to maximise cash flow while continuing to benefit from capital growth.
But what do you do when your interest-only term is due to expire? Do you ask your lender for another five year interest-only term? Do you refinance into another interest-only loan? Or do you start paying principal and interest?
The answer all depends on your financial needs.
First, assess your current situation
It’s important to review your options with your broker or lender before your interest-only loan expires. It’ll take a little time to explore the next steps and depending on what choice you make, it may take a while to sign new contracts and tie up any loose ends.
Option 1: move to principal and interest repayments
Whether this is the right option for you or not, the first thing you should do is talk to your current lender or broker to understand the costs involved with your upcoming loan changes. You should also seek financial advice from an accountant or other professional.
If you start paying the principal and interest with your current lender, here are some things you’ll want to consider:
- New principal and interest repayments. If your loan term is 30 years, when your five years’ interest-only term runs out you’ll only have 25 years to pay back your principal, plus interest. This means your monthly repayments may be higher than you think. For example, monthly repayments (interest-only) over five years for a 30-year term $500,000 loan at 4% would be $1,666.67. After five years, the principal and interest repayments on the remainder of the loan for 25 years would be $2,639.18 (compared to $2,387.08 over 30 years).
- Potentially lower interest rate. By switching to principal and interest, you might be able to secure a lower interest rate.
- Your tax deductions may change. Generally speaking, when you’re on principal and interest repayments, only the interest and fees portion of your repayment can be considered a deductible interest expense for tax purposes. You should seek financial advice from an accountant or other professional to discuss your particular situation.
Option 2: get an extension from your existing lender
If it’s possible to extend your interest-only loan term with your current lender, they will likely reassess your financial situation to ensure you have adequate cash flow to cover principal and interest repayments over a shorter period. If you do end up extending your interest-only period for another 5-year term, then you’ll need to repay the principal amount over 20 years.
Option 3: refinance with a different lender
If paying principal and interest doesn’t suit your current situation and your current lender does not allow interest-only extensions, you may choose to consider refinancing with an alternative lender.
Here’s what you’ll need to consider:
- Interest rate. One of the main reasons most investors consider refinancing is to secure a lower interest rate. Here is a simple example to illustrate the possible benefits. Let’s say that your current home loan is $600,000 at 5% for 30 years. Over the full loan term of 30 years you’d pay $559,535 in interest. If you secured an interest rate of 3.5% rather than 5%, you’d end up paying $369,937 in interest – that’s savings of $189,598.
- Extending your investment loan term. It is important to remember that if you choose to refinance a 30-year loan with another lender after your 5-year interest-only term expires, you’re adding another five years to your loan term and paying interest over 35 years.
- Refinance costs. Depending on how your current loan is set up, there may be costs involved with refinancing to a new lender.
Compare your options, shop around
When the end of your interest-only term comes around, you’ll be faced with several options: refinance, extend, or move to principal and interest repayments. If you’re considering refinancing, don’t be afraid to venture beyond traditional bank lenders – you might find the value and service of a residential lender like Bluestone a better fit. With any of these choices, it is important that you seek financial advice from an accountant or other professional.