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
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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.
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.)
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.
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.
The benefit derived from an interest-only home loan will depend on what type of borrower you are.
There are a number of disadvantages to be aware of, depending on your reasons for seeking an interest-only home 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:
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