Interest-only home loans

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 against the potential drawbacks before you commit to the loan. Learn about interest-only loans and compare lenders’ offers here.

By Yvonne Taylor   |   Updated 18th March 2020

Comparing interest-only home loans for $450,000.00 over 30 years.

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What is an interest-only home loan?

The majority of home loans are ‘principal and interest’ loans. Borrowers are required to repay a portion of the loan principal, along with periodic interest charges, every time they make a regular scheduled repayment. As a result, the loan principal gradually declines. At the beginning of the loan term only a very small amount of the principal is being repaid, but as the years pass, loan principal repayments account for a larger and larger portion of the periodic repayment. The last few repayments are almost entirely repayments of the remaining loan principal amount.

But interest-only loans are different. As the name implies, the borrower is only required to repay interest charges when making regular repayments. As a result, the required weekly, fortnightly or monthly repayment will be lower than it would have been if a portion of the loan principal was also being repaid. The loan principal does not reduce but remains the same throughout the interest-only period of the loan.

Are interest-only home loans a good idea?

Interest-only loans can be a good idea for certain types of borrowers, provided they are aware of some of the potential pitfalls. (See more details of advantages and pitfalls below.)

In what circumstances are interest-only loans offered by lenders?

There are four situations in which interest-only home loans may be offered:

1. Interest-only home loans are typically offered to borrowers who are having a new home built. An interest-only home loan 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 loan principal amount has stabilised, the loan will usually revert to a standard fixed or variable interest rate loan, where each periodic repayment includes a portion of the loan principal as well as interest.

2. 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 loan. 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, 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.

3. An interest-only home loan can also work where the borrower has a limited budget and can only afford to make interest repayments, without repaying any of the loan 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.

4. Borrowers who are buying an investment property may choose an interest-only home loan in order to maximise their tax deduction.

What is a typical term for an interest-only home loan?

An interest-only home loan term may be anywhere between one and five years. At the end of the interest-only term, the loan will revert to being a regular loan where repayments include interest plus principal. As a result, the required repayment will suddenly increase.

What are the benefits of an interest-only home loan?

The benefit derived from an interest-only home loan will depend on what type of borrower you are.

  • If you are buying an investment property, an interest-only loan will deliver a larger tax deduction for the same repayment amount than a ‘principal and interest’ loan.
  • For borrowers on a tight budget, kicking off the loan with an interest-only period means that repayments will be lower at the start. This can also be useful if you need to carry out expensive renovations in the early years.
  • Interest-only loans work well for construction loans and bridging loans.

What are the disadvantages of an interest-only home loan?

There are a number of disadvantages to be aware of, depending on your reasons for seeking an interest-only home loan.

  • If you can only just afford the loan repayments during the interest-only period, you may be unable to afford the repayments when the interest-only period comes to an end and you need to start including a portion of the loan principal in your repayments as well as interest. Your repayments may increase significantly.
  • The loan principal will not reduce, so if property market values are falling, or you need to sell your home because your circumstances have changed, there is a risk that your loan principal owed will end up being greater than the value of the property on which it is secured. This is known as ‘negative equity’.
  • The interest rate offered for an interest-only loan will usually be higher than the rate offered for a ‘principal and interest’ loan.
  • Interest-only loans usually work out to be more expensive in total over the life of the loan. This is because there has been no reduction on the loan principal in the early years of the loan, so you will pay more interest in the long run.

What is the best way to manage an interest-only loan?

Firstly, work out what the amount of your periodic repayment will be once the interest-only period ends, to make sure that you will be able to afford it.

During the interest-only period, try to maximise the cash you leave in your mortgage offset account (if you have one) so that your interest payments will be lower. You can use this cash as a buffer once your repayments increase at the end of the interest-only period.

When the interest-only period nears its end, try to gradually increase the repayments you are making until they are equal to the required repayment once the ‘principal and interest’ period kicks in. This will help you to get used to the idea that you will have less spare cash.

At the same time, take a look at your budget to see if there are any savings you can make so that you can more easily manage the increased repayments.

If the end of the interest-only period is approaching and you think you will not be able to meet the increased repayment amount, you have the options of:

  • Asking for a further interest-only period with your existing lender
  • Trying to negotiate a better interest rate for the ‘principal and interest’ loan with your existing lender
  • Asking your existing lender to increase the loan term in order to reduce your periodic payments
  • Refinancing your loan with a new lender, which may incur extra fees for refinancing

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