An interest-only home loan is a type of home loan where the borrower is only required to make repayments towards the interest being charged on their loan, rather than both the interest and their home loan principal (i.e. the loan amount they borrowed).
As home loan repayments are typically composed of both a principal component and an interest component, opting for an interest-only home loan (or for interest-only repayments on a different home loan) will typically see you making smaller repayments than if you’d opted for principal and interest repayments.
The term ‘interest-only home loan’ is a tad misleading though – like the fixed rate period on a fixed rate home loan, the borrower typically only gets an initial stipulated period of time in which their repayment type is interest-only, rather than that being the case over the entire life of the loan.
This initial set period will typically last between one and five years, during which only the interest component of the home loan is paid. This means that when the interest-only period ends, no progress will have been made paying down the principal amount.
When it comes to home loan repayment types, you’ll be tossing up between interest-only and principal and interest repayments. While the differences between these two types of home loan repayment are ostensibly evident from their names, there are some additional ramifications worth considering.
With a principal and interest loan, you’re paying off both the borrowed amount (principal) and the interest being charged on said amount right from the beginning of the life of your loan.
This means you’ll initially have a higher repayment amount than you would if you’d opted for an interest-only loan; but because you’re reducing the size of your home loan principal, you’ll see reducing interest costs as your loan term progresses and lower total interest costs over the life of the loan.
Conversely, while interest-only home loans afford you lower repayments in the short term, they’re typically a more expensive loan type in the long term, as you’ll pay much more in interest costs than you would on a principal and interest home loan.
Additionally, your interest-only period counts as part of your loan term, so you’ll end up with a smaller time frame in which to pay off your (as of yet untouched) loan balance.
For these reasons and more, it’s worth seeking professional advice before committing to an interest-only home loan or switching to interest-only repayments. You may want to speak to your lender or a mortgage broker about your financial situation and whether an interest-only home loan might be suitable for you or not.
So far this has sounded a bit like a cautionary tale but rest assured that interest-only home loans can be an invaluable avenue for certain types of borrowers. Depending on your financial circumstances and cashflow requirements, an interest-only home loan could even be your best option.
So, let’s explore the various types of borrowers and financial situations that might suit an interest-only home loan and interest-only home loan repayments.
Those with investment loans may stand to benefit from an interest-only period owing to some specific tax benefits available to property investors – namely, being allowed to claim the interest component of one’s investment home loan repayments as a tax deduction.¹
Combine this one piece of tax law with an interest-only investment home loan and you, at least on paper, may end up with home loan repayments that are mostly (if not entirely) tax-deductible.
However, if you’re looking to leverage your home loan repayment structure to gain a tax benefit, we recommend you seek professional advice from both taxation and property investment experts.
If you’re going back to university, have scaled back the hours you’re working, are going on parental leave or otherwise know your income will decrease soon, an interest-only period could help you get by.
If paying down your home loan isn’t your highest priority at the moment, you may view an interest-only period as an opportunity to either boost your savings account or pay off other debts like a credit card or personal loan. However, you’d have to talk to your lender to see if this is an option available to you.
Regardless of which of these categories you might fall into, you’ll want to be aware of the potential downsides of switching to interest-only repayments and be sure you’ll be able to meet your principal and interest mortgage repayments at the end of the interest-only period. You may want to seek professional advice before making any firm decisions.
As we’ve already mentioned, interest-only home loans come with a delicately balanced set of upsides and downsides which make them appropriate for a select few types of borrowers. We’ve summarised these below.
|Your repayments will be lower during the interest-only term||Your principal amount isn’t going down, meaning you’re not making any progress on your home loan, and you won’t have built up any equity|
|It could potentially give you the financial space necessary to pay off smaller, more pressing debts||Your home loan repayments will be significantly larger once your interest-only period ends|
|The tax ramifications of an interest-only mortgage can be potentially advantageous to property investors||Your overall home loan interest charges will be significantly higher than if you’d opted for principal and interest repayments|
|Interest-only home loans generally come with higher interest rates than principal and interest home loans, and if you’re on a variable interest rate, you’ll be vulnerable to sudden interest rate increases|
If you’re nearing the end of an interest-only period, you might be worried about adjusting to larger principal and interest repayments. If so, there are a few steps you could take to prepare yourself for the change, both mentally and financially:
Once your interest-only period expires, you’ll be required to start making principal and interest repayments. These will be larger than your former interest-only repayments due to the addition of the principal component.
If you’re an investor rather than an owner-occupier, you may be able to extend your interest-only period, but this will depend on your lender and what they allow. You could also consider refinancing if there’s a better-value home loan available that still ticks all the same boxes as your current home loan.
Depending on your home loan and the lender you’re with, you may have the option of switching to interest-only repayments for a stipulated maximum period of time. Lenders may offer this as a home loan feature for borrowers who need temporary cashflow relief or are experiencing financial hardship.
Interest-only home loans will always be more expensive than principal and interest home loans owing to their inflated interest costs. Because none of the repayments you’re making are going towards your home loan principal, they’re effectively ‘wasted’ money in terms of making progress on your home loan.
Add these ‘wasted’ repayments to the costs of paying off the home loan once you revert to principal and interest repayments, and you end up with a far larger total loan cost than if you’d started off making principal and interest repayments in the first place.
Being on an interest-only home loan won’t stop you from making extra home loan repayments – but if you’re on a fixed-rate, interest-only home loan, you’ll likely have a yearly limit on the amount you can make in additional repayments, whether they’re regular or lump sum repayments.
So, while you’ll still be able to make additional home loan repayments, you’ll want to keep an eye on the total value of your extra repayments to avoid incurring a fee. If you’d like to be able to make unlimited extra repayments without incurring a fee, you could potentially refinance to a variable rate home loan, which typically allow for unlimited additional repayments.
If you’re in the market for an interest-only loan (whether for a residential or investment property), there are a few things you should look out for:
You can also speak to a lender or mortgage broker if you’d like some help sifting through home loans and deciding which one’s right for you.