Interest only repayments come with risks

It can tide homeowners over if they haven't sold the old house before buying a new one. Photo / Michael Craig

When property prices go stratospheric, interest-only mortgages become popular. Monthly payments on interest-only mortgages are less because you're paying only interest, not principal (the amount you borrowed).

For example, principal and interest payments on a $480,000 loan at 6.25 per cent over 25 years come to $3,166 a month. The cost on interest only is $2,500.

Interest payments on principal and interest mortgages reduce over time as the capital is paid off. However, interest-only mortgage repayments remain much the same because the capital is not paid off.

Interest-only mortgages enable homeowners and investors to service a larger mortgage than they could otherwise afford. Other reasons for going interest only include:

•It can free up money for renovation.

•It makes servicing a mortgage easier after a drop in income.

•It improves cashflow for investors.

•It's tax efficient for investors, who can claim the interest as an expense, but not the capital repayments.

It can tide homeowners over if they haven't sold the old house before buying a new one.

The big "but" is that the mortgage will have to be paid off at some point, even if inflation does eat away at the value of the debt. That may not be as bad for investors who will pay the mortgage off when they sell.

After a year or two as their financial situation eases, most homeowners switch back to a principal and interest mortgage.

In theory it's not possible to get an interest-only mortgage for more than five to seven years, says mortgage broker Geoff Bawden, director of Q Advisor Group. However, banks don't want to lose their investor clients in particular and have been rolling those terms over of late. They will also roll over homeowner interest-only loans if the borrower is fiscally sound, adds Bawden.

One danger of interest only is that unless house prices continue rising you won't be building equity in the home. Falling house prices put the owner in a vulnerable position. Lenders can recall the loan.

The biggest risks from interest-only mortgages are faced by first time buyers and those who have bought their homes within the past five years or so. That's because they've never seen the downside of the property market and they haven't had much time to build up equity.

If the property falls in value a lender can decide that the loan-to-value ratio isn't high enough or even negative territory and can force a mortgagee sale. It happens. And if the sale price is less than the mortgage owed, the bank requires the shortfall to be paid off.

Negative equity isn't seen that often in New Zealand. But it can happen. Many thousands of UK homeowners' properties plunged into negative equity in the 1990s and the following decade did the same to homes in Ireland.