Interest-Only Mortgages

This article is current as at 1 September 2021.

Interest-only mortgages can be the right strategy in certain circumstances. Unfortunately freeing up money in order to go on holiday isn’t a good reason. Neither is freeing up money to buy that life sized replica Iron Man suit.  Put aside your dreams of being Tony Stark and read on for a look at when interest-only mortgages could work in your favour.

Why don’t the banks like interest-only mortgages?

The answer is largely to do with responsible lending. Having a large mortgage as you approach retirement is not a good position to be in. Therefore the Reserve Bank wants to see you paying down your mortgage. To appease the Reserve Bank, most banks limit the amount of time you can have an interest-only mortgage. 

Are interest-only mortgages available in New Zealand?

24.7% of new mortgages in June 2021 were interest-only, so it is very much a strategy for some property owners. This number may be slightly skewed as some of the banks' revolving credit accounts are always interest-only. ANZ in particular only offer an interest-only "Flexi" account and their lending makes up ~35% of the overall mortgages written. It could be assumed that, without revolving credit accounts, around 20% of new mortgages are still on interest-only.

However, looking at the statistics regarding interest-only vs principal & interest mortgages there is a definite trend downwards. In June 2021, interest-only mortgages made up 20.9% of the existing mortgage market. That's down almost 9% from the previous year when interest-only mortgages made up 29.8% of the existing mortgage market. Looking further back, they made up 38% of new lending in August 2016. The trend will likely continue down further as finance is made harder for investors.

How long can I stay on an interest-only mortgage?

Bank policies vary. Typically the banks will allow interest-only for 2 years for own home and 5 years for investment property.

Is an interest-only mortgage a good idea?

Interest-only mortgages aren't inherently bad. There are situations when diverting the money from your mortgage to another source might be a good idea.

The obvious example is to pay off higher interest loans or credit cards. If your mortgage is at 3% and your credit cards are charged at 20% then it makes complete sense to prioritise reducing your credit card debt. But be careful that you don't pay down these cards only to go back to your old spending habits. As you pay down your credit card, reduce the limit so that you're not tempted to spend. 

If you're a first home buyer who received help from your parents, you may want to focus on paying them back first. Often this is a condition required by parents in order for them to be able to manage their own financial responsibilities.

Interest-only mortgages as an investment strategy

Investors have traditionally used interest-only mortgages for investment properties as any interest was tax-deductible. You would then put all of your money into paying down the mortgage on your personal property. However in March 2021 the Government announced it's phasing out tax-deductions on investment properties from October 2021. As such, this strategy is becoming less relevant. However we are hearing a lot of accountants are still recommending investors continue with this approach. This is for two reasons:

1. Any investment properties bought prior to March 2021 will still receive some tax benefits through to April 2025. 
2. The interest on investment properties may become tax deductible again due to a change in policy. In that case having most of your debt on your investment property rather than your personal property will maximise future tax deductions.

The key point is you should have a good reason for having an interest-only mortgage. The strategy should always be to pay your debt down as fast as possible in the most efficient way.

How do I manage the interest-only period restrictions? Can I refinance?

As mentioned above, banks these days allow interest-only mortgages on an investment property for a maximum of 5 years and on a personal property for a maximum of 2 years. After that, you are required to start paying principal and interest on all mortgage accounts. This is the case even if you are over-paying against the personal property part of your mortgage.

Plenty of our clients are striking this problem. As they approach the time limit, banks require the clients begin to pay principal and interest.

You will need to explain to the bank why in your circumstances continuing with an interest-only mortgage makes financial sense. If the bank still refuses to extend the interest-only period, the only way forward is to refinance your lending to another bank. This allows you to reset the interest-only period limit. This is not the optimal outcome but is something we're seeing more and more.

If you are going to refinance to another bank because your interest-only period is up, you must make sure that the structure at the new bank is correct. Always remember that you may need to factor in break costs if you are changing banks too (here's an article on calculating break costs).

Can I get an interest-only loan if I am approaching retirement?

As you approach approximately 50 years old, the banks will become more and more hesitant about offering interest-only mortgages. After 5 years on interest-only, a now 50 year old may be within 10-15 years of retiring. You would need to reassure the bank that you could make significantly increased payments to your mortgage after your interest-only period is done. As such you will need to jump through some extra hoops.

What happens at the end of an interest-only period?

For almost all the banks, when your interest-only period finishes, the loan simply automatically converts to a principal and interest payment. 

ANZ are the only exception to this where a brand new account must be created. Otherwise their system tries to pay off the mortgage and you end up hundreds of thousands of dollars beyond your approved limit. This is a limitation of their computer system; it is not meant to force you to pay off your mortgage any faster.

Can I get an interest-only mortgage if I owe more than 80%?

If you only own one home and you are at over an 80% loan to value ratio, the bank will be very hesitant to allow you to be on an interest-only mortgage. This is to manage both your and their financial risk. Borrowers at a high LVR are at risk of having an underwater mortgage if the property market crashes. Meaning if the value of properties in your area drop by 20%, you will owe more than the property is worth. This is obviously high risk for both the bank and the borrower. Once you have paid your mortgage down to less than 80% LVR the bank will deem you to be in a much more secure financial position.

Can you make principal payments on an interest-only fixed loan?

This may surprise you but at most banks you can make additional principal payments, without break cost penalties. Most banks either allow you to increase payments or make a one-off lump sum payment on your loan, even if it's an interest-only loan. So if you find yourself with extra income (wouldn't that be nice!) or a lump sum of money (yes please), you may still be able to pay down your mortgage without incurring fees. Check with your mortgage broker or your bank to find out the rules attached to your mortgage. 

So who should look at interest-only loans?

If your mortgage is...

• a mix of personal and investment property and the investment portion is on principal and interest,
• you have other debt you need to pay down sooner, or
• you are about to be moved from interest-only to principal and interest AND it is in your best financial interest to remain on interest-only

... speak to a mortgage broker and, if applicable your accountant. They can give you advice specific to you. The broker can then manage any changes to your mortgage as a result.

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