Interest-only lending has been traditionally very popular with Australian residential property investors. Several years ago, when lenders offered interest-only lending as an option with no rate penalties, investors would naturally flock towards these structures. Why wouldn't you? It gave you extra cash flow so you could keep investing.
Unfortunately, APRA has since intervened and forced lenders to change their treatment of interest-only loans. This has changed the attractiveness of interest-only lending to the point where it may simply not be worth it any more.
The first main change is that lenders have increased the rate at which they offer interest-only (IO) loans. This rate is currently at a typical premium of around 0.4% to 0.5%. This can add up to be a significant amount of extra interest paid over the life of an investment loan. Having an IO period also defers the repayment of the principal so you end up paying even more interest over the life of the loan.
The next change is that lenders are currently assessing the ability of the borrower to repay the loan at much higher rates - this is called stress testing. The current "assessment" rate is around 7.4%. So even if you are getting a loan at 4.0%, the lender will still assess your servicing in the background at 7.4%. The bottom line is that banks will only lend if you can service the loan at a significantly higher rate.
The other change is that lenders are now assessing your current lending at the remaining term AFTER any IO period has been completed. So if you have a 25 year loan term with 5 years IO included, then the banks will assess your ability to repay the full loan at an adjusted term of 20 years. When this is done at the 7.4% assessment rate then you actually REDUCE your borrowing capacity with the lenders by holding IO loans. This is very counter-intuitive in that you would think holding IO means you have greater cash flow and the ability to borrow more - but it is having the exact opposite effect.
In summary, APRA has forced lenders to change the way they treat interest-only lending. It was once the bread and butter of the investor's financing portfolio, but has not become an inhibitor to investment growth due to higher rates and tighter assessment methods. Next time you look at investment lending, you may want to reconsider interest-only and stick with principal + interest repayments.