By global standards, Australian banks hold an unusually high percentage of interest only loans. More than 40% of mortgages held by the big four banks are currently interest only arrangements.

The Australian Prudential Regulation Authority (APRA), the banking regulator, has assessed the risk as too high. In an attempt to cool off soaring property prices in the eastern states and rising debt risks Australia wide; APRA has decided to take a conservative approach by implementing regulations that require the banks to increase the proportion of principal and interest (P&I) loans against interest only loans. They’re also tightening up the criteria for interest only borrowing.

All Australian banks are now restricted to lending no more than 30% of new loans (which includes extensions of existing loans) as interest only.  

Clearly, banks will be cutting back their interest only lending to meet APRA demands. This will make it tougher and more competitive when applying for an interest only loan as an investor or an owner-occupier.

But, what does this mean for you as an existing interest only borrower?

The new regulations can have a huge cash flow impact – particularly if you have an investment property and you are also being squeezed by lower rental returns. Lenders have responded to APRA’s new stance by hiking interest rates on new and existing interest only loans – some up to 0.8%pa.  On an average mortgage of $500,000, borrowers will outlay a further $4,000 per year on interest!

As well as the burden of additional repayment costs, existing borrowers will find it harder to refinance or get additional interest only funds, particularly if you’re already close to the limit of your loan to value ratio (LVR). 

In line with APRA’s aim to lower debt risk, banks are tightening up their stance around LVR – and may not even consider you if your loan request is beyond your LVR limits. So, if you’re already adversely affected by the interest rate increases this could push you over your LVR limits leaving you no room to even refinance your existing loan, nevermind ask for additional interest only funds.

Your finance broker will be able to help you understand how this new lending environment will affect you.

In the meantime, here are a few tips to avoid being slugged.

Switch to Principal and Interest (P&I) Repayments

The obvious choice.  Not only would you avoid the ‘Interest Only Levy’ but some lenders have applied further reductions to their P&I interest rate to incentivise customers to make the switch.

Consider a Fixed Rate

If for reasons of cash flow or taxation you prefer to remain on interest only, there are still a handful of lenders offering interest only fixed rates at levels lower than variable interest only.  But, be sure of the fixed rate’s limitations before making any changes.

Use an Offset Account

By stashing spare cash away into an Offset Account, you reduce the daily balance the banks use to calculate your interest charges.  These accounts are available on most variable rate loans, but be sure to compare the additional cost to have this facility with the interest savings you stand to make.