What Is An Interest-Only Home Loan & How Does It Work?

Want to buy a home or investment property but need lower mortgage repayments? Consider an interest-only loan.

What is an interest-only home loan? Well, these are different from most of the other standard home loans because, for a set period of time, the repayments you make only cover the interest on the component of the loan without paying any principal portion. Standard home loans require you to make principal and interest repayments simultaneously to reduce your home loan balance. 

Although they may seem appealing because of their list of benefits, interest-only home loans should be well considered before going ahead because of their negative features, too. Here’s everything you need to know before making a decision.

How an Interest-Only Loan Works

A standard home loan is typically split up into two parts: principal and interest.

• The principal is your loan balance: the amount you borrowed.  
• The interest is what the lender charges you on your outstanding loan balance.

If you have an interest-only home loan, during the agreed period, your repayments only pay the interest on your home loan. As a result, your loan balance effectively remains the same over this period.

You can arrange with your lender to switch between interest-only and principal and interest repayments throughout your loan, but your lender may limit how long you are allowed to have interest-only periods. 

For example, some lenders may have the following rules when you request a new or extended interest-only payment plan:

• Five years is the maximum interest-only period for owner-occupiers and ten years for an investment property.
• If you want to extend the interest-only term, you may need to get your loan reassessed. 
• If you’re on Principle and interest repayments and want to revert to interest only, you may require to do a full assessment.

Once you have reached the end of your interest-only period, your home loan repayments will automatically change to principal and interest. 

Make sure you know the expiry date because, at this point, your repayments will increase as you start paying off your loan balance. You need to prepare for this increase so you can remain in control of your repayments.

Who Can Benefit From Interest Only Loans?

Interest-only repayments are lower than paying principal and interest combined, so many people utilise a period of paying less to help them manage their finances and maximise their cash flow. 

Here are some other circumstances where it can be beneficial to pay only home loan interest for a set amount of time:

• If it’s an investment loan it’s recommended to have this loan as interest-only so you can pay down your owner-occupied property faster with the extra funds. 
• Extra cash flow can be used to get out of other higher interest rate debts faster.
• Having savings is always prudent for unexpected expenses, such as a new baby, illness, death, or divorce.
• Investors can potentially reap tax benefits by offsetting their rental income against their costs. 
• Additionally, lower repayments mean access to extra cash flow otherwise spent on mortgage repayments that can be used in other investments such as Shares.  

Cons of Interest-Only Home Loans

Some cons need to be considered before taking out an interest-only home loan.

• An interest-only loan has lower repayments during the interest-only period, but these will eventually go up once you start repaying the principal. This can come as a shock to your budget and lifestyle, so it’s imperative to cater for the jump in cost.

• The market interest rate is typically higher, which will increase the total amount of interest due.

• Because you don’t pay anything off the principal over the interest-only period, the amount you borrowed remains the same. If your property’s value doesn’t increase while you pay off the interest, you won’t increase your home equity because your repayments aren’t going towards the principal.
• Higher repayments due to the repayments are calculated based on the remaining principal and interest term. 

Example: Choosing Between an Interest-Only Loan or a Principal and Interest Loan

Charlie has been looking for an apartment to buy for quite some time. He eventually finds the perfect match and calculates that he’ll need to borrow $500,000. He would prefer to repay this over 25 years, so reviews different loans online. 

He had heard from his father’s friend, Donald, about a specific type of loan different from a principal and interest loan with an interest-only period of five years. Donald recommended Charlie use an interest-only mortgage calculator with a comparison rate of 4.8%.

Charlie found he would need to pay $2,010 for the monthly repayments for the period of the interest-only loan. After five years, the amount will increase to $3,250.

Although Charlie was initially drawn to the idea of lower repayments in the beginning, his father advised him that Donald is a seasoned property investor. His father suggested he shouldn’t be comparing himself with someone 30 years his senior and should instead chat with a mortgage broker. As the repayment of $3250 might be a shock to him after 5 years.

The mortgage broker helped Charlie decide a principal and interest loan would be a better option at this stage, with consistent repayments of $2,875, this is because the rates were cheaper, there were no reasons to go interest-only repayments while Charlie’s goal was to build up equity.

How a Mortgage Broker Can Help

As we have seen in Charlie’s case, going through a professional mortgage broker can help you make more informed decisions rather than hasty ones you may regret in the future. According to recent data, mortgage brokers wrote two-thirds of all new residential home loans between July and September 2021.

They have the knowledge to explain all your options to you in detail and consider your personal circumstances to determine what could be the best fit for you. Additionally, they can identify perks, features and loan products you may not have accessed on your own. 

If you are deciding between an interest-only loan or principal and interest repayments, contact our mortgage brokers today.

Disclaimer:

Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to property buyers and investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal, tax or investment advice. You should, where necessary, seek your own advice for any legal, tax or investment issues raised in your affairs.