Switching from Interest Only (IO) to Principal & Interest (P&I)
Switching from interest only to principal & interest is a process that is: -
(a) Required by your Lender, or
(b) A decision you make yourself.
Either way, it will impact your repayments and your financial position. Principal and Interest (P&I) loans have certain significant advantages, but deciding whether it is right for you depends entirely on our finance needs, objectives and individual circumstances. Comparing IO to P&I loans includes contributing factors such as the availability of IO loans, the rate premium charged and specific bank credit policy. Nevertheless, if you have decided (or had that decision made for you) to make the switch to P&I repayments, then there are certain things you need to consider and plan for beforehand so you make the right decision and are aware of the consequences.
1. Servicing Assessments
In most cases, if you are switching from IO to P&I with the same lender, there will be no need to undertake a new servicing assessment for your loan. This is because servicing assessments (ie. a bank process that reviews your income and expenditure in relation to your ability to repay a loan) are normally only required where the loan product chosen results in an increased risk to the bank. Interest only loans are inherently riskier products for the banks and that's why you pay more for them. They are riskier because you are not reducing the amount you owe the bank and therefore, if the value of your asset doesn't rise, or worse, drops, it affects their exposure. So, switching from IO to P&I is good in that it reduces the risk your loan represents to the bank and therefore you don't need to go through a new servicing assessment procedure.
2. Reduce Your Debt
Repayments for a P&I loan are calculated on the assumption that by paying the minimum monthly amount as stated on the loan contract, you will repay all principal during the term of the loan. The benefit of this is obvious. The higher repayment works in your favour as it (a) is a method of forced saving and increases you equity in your home, and (b) it reduces the amount of interest that accrues as the principal reduces over time. This is compound interest working in reverse, and never underestimate the power of reducible interest. It may take 25-30 years, but one finished, you own your home debt free.
3. Repayment Holidays
If you make additional repayments during the term of your loan and your circumstances changes (such as being in between employment or one applicant taking time off for parental leave), you may be able to request a repayment pause to your loan.
4. Lower Interest Rates
Interest rates are lower for P&I loans. Plain and simple.
5. Borrowing Capacity
You can actually borrow more with a P&I loan than an IO loan, as the servicing calculation is based on the number of years you actually repay the loan.
The only disadvantage to a P&I loan is not actually a disadvantage. Repayments are higher, but as shown above, these repayments work for you in the long run. Taking a P&I loan also means you don't get complacent with lower repayments and then struggle when P&I repayments start.
HOW TO PREPARE FOR THE SWITCH
1. Don't Trust Your Bank
Never rely on your bank to give you the best loan available , or the best rate. Banks are not in the business of giving you the best deal possible unless they are forced to. Use a broker who knows the market and has a good relationship with other banks; the majors and others.
2. Manage Your Expenses
The factor you have most control over in regard to your borrowing capacity is your living expenses. Reduce your credit card limits to what you need only, pay out any personal loans and/or HECS/HELP debts if you have them, review your spending habits and start to reduce them. If you can, reduce your spending to what you can reasonably accept for a period of 2-3 months prior to applying for your new P&I loan.
3. Review The Term
Refinancing your existing loan with a new 30 year loan will reduce your repayments, but extend your repayment period. Whether this is a good idea or not is based on every applicants individual circumstances, but if you go through the cost/benefit exercise with your broker, you will hopefully be able to make a well informed decision.
While switching from interest only to principal and interest may be a bit daunting, if you are well prepared and know how to get the right loan for your needs, you will be in the best possible position. Speak to a broker you feel comfortable with and ask them for help. A good broker will give you the benefit of their knowledge willingly and provide as much assistance as you need. I can tell you from personal experience, a good broker is always happy to make sure their clients get the better of the banks!