Interest Only really a Time Bomb?
Updated: Dec 18, 2018
I'm sure you've read the Interest Only Time Bomb headline before in the papers or online. I know I have, but the interesting thing is none of the articles I've read actually just shows you the numbers!
For the readers who don't know what this interest only time bomb, here's the short version. Basically there's borrowers out there with interest only loans and at the end of the interest only term they will revert back to principal and interest repayment (i.e. you have to pay your interest and some of the money you borrowed back). Pretty simple right...
This has become a big thing in Australia because there's a Banking Royal Commission looking into the misconduct of Banks and the Banking regulators have been putting pressures on Bank's to take it easy on lending and to be more responsible at lending.
As a results, most Banks have or are changing policies around how many years a 30 year mortgage can be interest only. i.e. A customer cannot extend their interest only period forever effectively creating an equity line or revolving facility.
This issue is then compounded by
Falling property prices, i.e. you can't borrow back what you have repay.
Tightening in Bank's lending criteria, i.e. you now can't even borrow the money that you the Banks have said you could borrow before.
Anyways, enough of the details you can read elsewhere. Here's the interest only time bomb numbers so that you can figure it out for yourself.
bought a house valued at $500,000
borrowed 80%, i.e. $400,000 at 4% interest rate for 30 years
There's 2 options you can either 1) Base Case: go principal and interest for 30 years or 2) interest only for 5 years, followed by interest only for 25 years.
Here's what it will look like. You can adjust the numbers to suit your situation so you know what you need to prepare yourself for (click here for mobile friendly version):
Interest Only Time Bomb Calculator
Disclaimer: This calculator was created to provide landlords and property investors with information to make an informed decision on the effects of your loan switching from interest only to principal interest. This information should not be used as advice. Please seek financial advice from your finance professional before making any financial decisions.
The issue here is when you go on interest only for the first 5 years, you will get into the habit of paying $16,000 as oppose to $23,132 in the traditional scenario. When you revert back to principal and interest, you will get a rude shock when your minimum repayment increase from $16,000 to $25,605 (60% increase or $9,605 more).
You might be asking why is the repayment higher than the traditional scenario. This is because you now have to pay back your entire loan amount in the remaining 25 years, i.e. you need to catch up on the first 5 years where you have not contributed to any loan repayment.
What this means
you will likely cut back on your discretionary spending to pay your mortgage, yes that means no more #smashedavos toasties and maybe quit drinking coffee ($4.5 x 5 days a week x 52 weeks a year = $1,170).
This is actually very bad for the economy because you are taking spending out of the economy and giving it to the Bank the strengthen their balance sheet by reducing the loss they would incur if you were to default. If you spend that coffee and bought that #smashedavo toasties you would be helping the local businesses hire staff to make that for you. If you don't, they may go bust if enough of you are in this situation.
i.e. Economic theory says reducing consumption = bad for economy as a whole.
I believe the interest only time bomb is real. The question is how many people are in this situation and more importantly whether you are or potentially its coming.
If you guys are interested in seeing some ideas of how you can get yourself out of this situation please write in the comment below too and i'll prioritise what I write based on what you want are more interested in.