Loan Tip: Why Interest Only Loans Decrease Serviceability

Interest only loans hurts serviceability in 3 ways

With the majority of lenders having interest only loans will adversely hurt a borrowers borrowing capacity. This is because they base serviceability on the minimum repayments over the life of the loan after the IO period ends.

If you were to go for a 30 year loan with the first 5 years as interest only would be assessed as a 25 year PI loan.

However, if you were to go for a 30 year PI loan it would be assessed as that – a 30 year PI loan.

The repayments on a 25 year loan are higher than a 30 year loan.

Example

$500,000 at 3% p.a. the repayments would be:

$2108 per month if 30 year PI loan, or

$2,371 per month if a 25 year PI loan

That is a difference of $263 per month


The extra $263 per month hurts serviceability, but IO rates are also generally higher too, so the higher rate can also hurt serviceability with some lenders.

In addition, with a PI loan with each payment your debt is reducing and the less debt you have the better for servicing

But note that there are a few lenders where interest only can actually improve serviceability.

 

That's great Terry thanks for the insight as there seems to be a few different opinions on this even among brokers.

Across a portfolio of several properties this could make quite a difference to one's serviceability and ability to purchase another or not?

Any idea on the lenders were IO improves servicability and why that is?

 

There's no debate amoungst brokers on this, there's only exceptions with non-bank lenders. Terry's post is accurate on bank policy, which is enforced by APRA.

There are lenders that operate outside of APRA regulation (note there is a difference between a 'bank' and another 'lender', regulation levels are a function of this). As non-banks are not subject to the same regulation, lenders with alternate funding sources are able to do things a little different as they're regulated by ASIC, which is not quite as stringent.

This is why the likes of Pepper, Bluestone & Liberty will lend more because they treat existing loans as a function of the existing repayment (plus a margin), not a calculation that's based on the loan term.

If you do the math, you'll find that actual repayment + 30% is significantly lower than a P&I calculation using an assessment rate, even on a 30 year loan term, let along a 25 year loan term. Hence an existing IO loan will have a more favourable result with many non-bank lenders.

The caveat is that after an IO period ends, you're now on 25 year loan term repayments, and those same lenders will assess the loan more harshly than they would have had it been P&I from day one.

This has been discussed many times previously on these forums and if you understand the policy reasoning, you'll find that the discussions have always been consistant.

 

Yes I think there is no debate. IO loans clearly do hurt borrowing capacity with many lenders.

 

It can/should hurt your servicability, but its all dependent on your debt and income levels.

Some smaller lenders assess loans differently with the rates applied for negative gearing and stress testing which at times are better the mainstream banks.

Pepper is a bank where IO is favourable.

 

This got me thinking, does a fixed rate loan help with serviceability? Or would serviceability be accessed on the variable equivalent. For example, can I get a 1 year fixed rate loan at the cheapest possible interest rate to boost my serviceability a little, as opposed to going variable or 3/4 year fixed.

 

Note that where the borrower is a company this could lead to higher serviceability for related companies and directors