Interest Only Loans and Debt Servicing

  • 28 May, 2021
  • Carlo Colangelo

Interest Only Loans have been favoured by homebuyers and property investors for many years as way of preserving cash flow.

(If you are not paying off principal, then you have more cash available for other purposes).

For property investors, not paying principal also has the advantage of higher interest deductions and as the debt is not being amortised.

However, whilst Interest Only Loans are still available, the approach by Lenders when it comes to assessing serviceability, has tightened over recent years.

Interest Only Loans – Can it be Repaid?

Today, when seeking or renewing interest only loans, borrowers will need to demonstrate they can:

  • Afford to repay the loan over 30 years from current cash flow
  • and continue to service the borrowings should interest rates rise

Combined, both the factors can significantly increase the amount borrowers’ need to cover to demonstrate they can service the loan.

Interest Rate Serviceability Margins

Lenders will typically add a Serviceability Margin of approximately 2.5% to a borrower’s actual interest rate.

They do this to confirm the loan can still be repaid in the event of future interest rate rises.

Alternatively, they may just use a Serviceability Rate of between 5.25% and 5.50%.

Whilst this may seem unfair given our current historical low rates, interest rates will increase at some point. By adding a Serviceability Margin, Lenders are seeking reassurance the loan can be repaid in the event rates do increase.

The last thing Lenders want to do is to force borrowers to sell property because the debt can’t be serviced. When this occurs, everyone loses!

Maturing Interest Only Loans

Lenders will typically approve Interest Only Loans for a fixed period then expect the loan to be repaid.

The approach taken will vary from Lender to Lender however they will generally either:

  • Expect the loan to be re-paid over a normal period, typically 30 years, or
  • Be repaid over the balance of the remaining term. That is, if the facility was originally approved for 30 years and had been interest only for three years, then they would expect the loan to be repaid of the remaining 27 years

Rental Income and Debt Serviceability

Whilst the approach taken in relation to rental income varies from Lender to Lender, rental income is often discounted by 20% for debt serviceability purposes.

The reason this is done is to allow for a period where the property may be untenanted.

Planning the Key to a Better Outcome

In our experience even established borrowers or investors find the approach taken to testing serviceability challenging.
However, this does not mean Finance is not available, but rather that planning, and preparation are needed before approaching Lenders.

It is about:

  • Understanding the lending landscape
  • Ensuring you have all the needed, current information available

And crucially, ensuring your finance structure is correct and tailored to your individual circumstances

Carlo Colangelo – The 500 Group – Mortgage Finance
Carlo Colangelo

If you would like to learn more don’t hesitate to give me a call.