ASIC released a report on interest-only home loans that provides some important guidance on your ongoing responsible lending obligations – REP 493.
A key take-away from this report is that you must be able to show ASIC that you have performed your responsible lending due diligence with your customer, if required. The report is focused on what you need to do when recommending an interest-only home loan to your customer, so that means you must be able to show:
That you understand your customer’s requirements and objectives.
Why an interest-only home loan meets those requirements, and
That you have explained to your customer and they fully understand the pros & cons of deciding to take out an interest-only home loan.
Of course, the best way to be able to show that you have met these requirements is to keep good records of your dealings with customers.
However, it is also important that you know what to cover off with your customers when discussing and explaining the pros & cons of an interest-only home loan.
So, what are the pros & cons of an interest-only home loan? What do you actually need to tell your clients to make them understand?
Smaller repayments. During the interest only period of the home loan, the customer’s monthly repayments will be lower than with a principal and interest loan.
Free up cash. Lower repayments mean your customer could use their available cash for other purposes that may be financially beneficial. These could use the money to pay off debts, make other investments, fund a loan to purchase another property, or to pay the cost of additional educational qualifications that may increase their earning potential.
Tax deductible for property investors. The interest on an investment property debt is usually tax deductible for property investors, as long as they follow the ATO rules. This can be very beneficial to property investors with regard to maximising their tax deductions and cash-flow. It should be noted, however, that owner-occupiers will not receive any tax deduction for interest if they take out an interest-only loan.
Benefits are ongoing for the life of the interest only term. Consumers can often choose an interest only term from 1, 3, 5 or 10 years. This can be very beneficial for tax minimisation strategies and financial planning purposes.
The consumer may not build any equity. Interest-only loan repayments do not help the consumer to build equity in their property. Unless property prices rise during the interest-only period of the loan, your customer will not have improved their financial position.
As soon as the interest-only period ends, the loan will revert to a principal and interest loan and the customer’s loan payments will increase. You should advise your customer to plan ahead for the end of their interest-only period. At that time, some lenders may allow your customer to renegotiate another interest only term. Or, if they convert to principal and interest, they may have to plan for increased payments. Other alternatives may include refinancing the loan, or selling the property.
An interest-only loan will cost more in interest over the life of the loan than a principal and interest loan. The cost differentials can be quite significant and should be clearly demonstrated and explained to your customer. For example*:
With a normal principal and interest loan for $500,000 at 4.78% p.a. based on an LVR of 80% over 25 years, the total cost of interest on the loan would be $357,766 over the 25 year period.
On an interest-only loan for $500,000 at 4.78% p.a. based on an LVR of 80% over 25 years with an interest-only period of 10 years, the total cost of interest on the loan would be $440,443 over the 25 year period, which means that the interest-only loan would cost the consumer an additional $82,676 in interest compared to a principal and interest loan.
It may be a better idea to pay down the principal while interest rates are low. Paying down as much as they can off the principal now could mean that when interest rates do rise, your customer would be paying those higher rates on a reduced loan size, which could mean lower loan repayments and/or paying less interest in the long-term.
As the ASIC REP 493 says, you need to be able to show that your clients understand the pros & cons of an interest-only loan and understand them. Obviously, each of your customers will differ in terms of their personal financial circumstances and goals, so not all of the pros will apply to everyone and the same is true of the cons. But make sure you are having those rigorous discussions during your discovery process and be careful to document them!
Again, this highlights the importance of full discovery of your customer’s circumstances as part of your responsible lending obligations. We also encourage you to continue to be vigilant about verifying income, assets and other influencing factors.
The full report is available here Download ASIC REP 493
*INFORMATION SOURCE: HTTP://WWW.CANSTAR.COM.AU/