An interest-only loan can be a useful way of getting a foothold on the property ladder, as long as you have carefully weighed the benefits of this particular type of home loan against the potential drawbacks before you apply. If you have an interest-only loan, your periodic repayments will consist entirely of interest charges, and the principal amount will not reduce. At the end of the loan term the full principal amount has to be repaid, unless the terms of the loan dictate that payments will revert to normal 'principal plus interest' payments after a specific number of years.
Reasons for using an interest-only home loan
There are four main situations in which interest-only home loans may be useful, and may be offered by lenders:
- Construction loan. Interest-only home loans are typically offered to borrowers who are having a new home built. This type of borrowing works well during the construction period, when progress payments are being made to the builder and the full loan amount has not been drawn down. Once the home is completed, and the total principal amount has stabilised, the loan will usually revert to a standard fixed or variable interest loan, where each periodic repayment includes a portion of the principal as well as interest.
- Bridging loan. If you already have a loan secured against your existing home, but want to buy a new property, ideally you need to sell your existing home first so that you can use the equity as a deposit against a new property. But it can be difficult to get the timing just right, and many borrowers find themselves in a situation where they need a bridging loan for a limited period of time, so that they can temporarily finance both properties and then lock in a standard loan on their new home once their first home is sold. Bridging loans will typically be interest-only loans.
- Lower loan repayments. An interest-only home loan can also work where the borrower has a limited budget and can only afford to make interest payments, without repaying any of the principal. In the past this was a popular option, but both the Australian Prudential Regulation Authority (APRA) and banks themselves have tightened lending conditions for interest-only loans, to avoid letting borrowers commit to loans they cannot really afford.
- Investment property. Borrowers who are buying an investment property may choose an interest-only home loan in order to maximise their tax deduction. Home loan principal payments are not tax deductible for investors, but they can claim 100% of their repayments as a tax deduction if they only consist of interest charges. Interest-only loans are also useful in a negative gearing situation, keeping payments low while the investor waits for the asset to hopefully increase in value as a result of a general lift in property values.