Interest-only home loans are a type of home loan that can offer a lower repayment, as you are only paying off the interest component of your mortgage. Depending on your situation, a good interest-only loan can help you manage your cash flow and keep your home loan repayments in check.
Here’s how interest-only loans work, the pros and cons of them, and who might be suited to one.
How do interest-only home loans work?
Having an interest-only loan means you will only be paying off the interest component of your mortgage for a certain period of time, usually between one to five years, and nothing off the actual amount you initially borrowed. After the interest-only period ends, you will start repaying both the interest and principal amount (i.e. the amount you have borrowed).
Fixed rates and variable rates are available for an interest-only home loan.
Interest-only vs. principal and interest: How do the repayments compare?
Interest-only loans (IO for short) are different from principal and interest loans, which are the more common loan type. With a principal and interest loan, you pay off both the borrowed amount (principal) and the interest on the loan right from the beginning, which means you will have a higher repayment amount than an interest-only loan; but as you are reducing the principal, the interest also reduces, making this type of loan cheaper overall.
Although interest-only loans can provide you with short-term relief in the form of smaller repayments, you aren’t paying off any of the loan balance, only the interest component. This means, the amount you borrowed from the lender is still there and not getting smaller. Your initial loan term will remain, and therefore your principal and interest repayments will become higher as the time to fully repay the loan has been constricted to a shorter time frame.
Before committing to an interest-only loan, give this careful consideration and speak with your lender to weigh up your options, you can also compare your options with Compare the Market.
Who is suited to an interest-only loan?
Quite often the leap from interest-only payments to principal and interest payments can lead to sudden ‘repayment shock’, where borrowers may find that they’re now struggling or unable to meet the new repayments.
Although this type of loan isn’t perfect, interest-only loans can be beneficial for some including:
- Investors: As a property investor, you could find value in an interest-only loan due to the potential tax benefits.*
- Those with changing financial circumstances: Say you’re experiencing a reduction in hours at work, welcoming a new addition to your family, or are going back to university for six months – an interest-only loan can help you get by temporarily by lowering your mortgage repayments.
- People who want to save or pay off other debt: Lowering your home loan repayments can give you some breathing room to pay off other debts you’re struggling with, such as high-interest credit card debt.
Speak to a mortgage broker, lending expert or financial advisor to determine whether an interest-only home loan is right for you.
Pros and cons of an interest-only home loan
As with any type of loan, there’s always pros and cons.
- Your repayments will be lower during the interest-only period. The obvious benefit to an interest-only mortgage is the lower repayments for the agreed term.
- You could enter the property market sooner. Interest-only home loans can help you to enter the market earlier if you can’t afford a principal and interest loan. However, this tactic can backfire if you find you can’t afford the higher repayments once the interest-only period ends. It’s generally not a good idea to buy a home if you can’t afford the full principal and interest repayments, so speak to a broker or a home loan specialist about your personal and financial circumstances, goals and objectives to work out if this is right for you.
- It can be a good opportunity for property investors. As well as having lower repayments, you may also be able to claim tax deductions for your rental property.2 For example, you can claim the interest on your property’s loan as a tax deduction,3 so if you have interest-only repayments, you can potentially claim the full value of your repayments.*
* Speak to a registered tax professional or visit the Australian Taxation Office (ATO) website for more information on anything tax-related.
- You’re not reducing your mortgage. As you aren’t paying off the loan principal amount (the amount of money you borrowed), at the end of the interest-only period you’ll still have the same amount of debt owing as you did at the start of the loan.
- Your payments will eventually increase. At the end of the interest-only period, your repayments will be higher as you’re now required to pay back both the interest and principal within the agreed loan term. For example, say you took out a home loan with a 30-year term and then chose to have an interest-only period for 5 of those years. Instead of paying the principal and interest back over a 30-year term, you will be required to do this in 25 years, resulting in higher repayments.
- You’ll have higher overall interest charges. Since you’re not reducing your principal (debt) during the interest-only period, it will continue to attract more interest than a lower debt would. Not only that, but there are generally higher interest rates on interest-only mortgages; as of September 2021, the current average interest rate for a principal and interest loan was 2.70% p.a. while interest-only loans sat at 3.60% p.a. – almost a full percentage point higher.1
- Your property’s equity will be affected. By not reducing your principal amount, you’re also not building your equity (i.e. the proportion of your property that you own). This can present a problem if you decide to sell during the interest-only period or your property’s value decreases, as you might end up owing your lender more than you signed up for.
How do I apply for an interest-only loan?
So, you’ve done your research, calculations and you know your budget. We can help you find an interest-only loan, right here and now!
Simply head over to our home loan comparison service to get started. Enter in your details (your property’s location and intended use (owner-occupied or investment), the loan’s purpose (new purchase or refinance) and the type of loan you want) and our service will bring up a range of different loans for you to compare.