What is an interest only loan and how do they work?
An interest-only loan may be ideal for you. Here’s a quick guide on interest-only home loans, what they are and how they work.
Before choosing a home loan, it’s important to understand the benefits and drawbacks. An interest-only home loan may suit those who want to make lower repayments at the beginning of their loan. However, it could cost borrowers more overall.
An interest-only loan may be ideal for you. Here’s a quick guide on interest-only home loans, what they are and how they work.
What is an interest-only home loan?
An interest-only home loan is a type of financing where the borrower only pays interest on the loan for a set period. During this time, the principal loan amount does not decrease meaning you’re not paying off the balance owed on your loan.
The repayments will only go towards the loan’s interest costs for a limited time. Usually, the interest-only period is between one and five years, depending on your agreement with the lender. When that period ends, the loan will revert to a principal and interest home loan.
Interest-only home loans are different from principal and interest home loans, where repayments cover the amount borrowed as well as interest.
How do interest-only home loans work?
When paying off an interest-only home loan, the repayment amounts only cover the interest owed. This means you're not chipping away at the principal, which is what happens when paying off a principal-and-interest home loan.
After the initial interest-only period ends, you will shift to making repayments for both the principal loan amount and interest. This usually results in a higher repayment amount for the remainder of the loan term.
To better illustrate the difference between an interest-only home loan and a principal and interest home loan, let's use the example below:
| Interest-only | Principal and interest | |
|---|---|---|
| Interest rate (variable) | 5.29% | 5.29% |
| Loan size | $600,000 | $600,000 |
| Loan term | 30 years | 30 years |
| Monthly repayments | $2,645 (during the interest-only period of 5 years) $3,610 (after the interest-only period) |
$3,328 |
| Total interest payable | $641,598 | $598,119 |
| Difference in overall interest charged | $43,479 more interest payable on an interest-only loan type over the life of the loan. | |
Take note, usually interest-only loans have higher rates compared to a principal and interest home loan. You can see how changing the interest-only period and the rate can affect the monthly repayments and total loan cost by using our online interest-only home loan calculator.
Since the home loan type affects the overall structure of your mortgage, changing it has a huge impact on the cost. Use an online home loan repayment calculator to see how the interest rate, payment frequency, and other factors can affect the overall cost of your home loan.
Benefits of interest-only home loans
There are some notable pros of an interest-only mortgage that make them an appealing choice for many borrowers. Here are some advantages to consider when you’re deciding on the right home loan:
Lower repayment amounts
Arguably, the biggest pro of an interest-only home loan is that the loan repayment amounts are lower for a set period. This can be helpful when you need some extra cash or you've experienced a period of lower income.
In line with the ‘extra-cash' component, you could potentially use this time to rebuild your savings, renovate the property, or purchase new furniture for the home.
Managing other debts
If you're struggling to keep on top of other debts, like car loan or personal loan repayments, an interest-only home loan may help you with making lower initial mortgage repayments. In this way, you have more capacity to pay off other debts, after which you can focus on keeping up with mortgage repayments.
Tax advantages
If you’re buying an investment property, the interest paid on the home loan may be tax-deductible, depending on individual circumstances. The interest on loans taken out for alterations, repairs, or renovations made on the property may also be claimed. Using an interest-only home loan for an investment property may allow you to make higher tax deductions and limit your investment costs.
Interest-only home loans could also have potential tax benefits for property investors looking to sell within the interest-only period. Tax advantages can vary significantly depending on your situation. Speaking with an accountant or tax expert may be a good idea to gain a clear understanding of potential advantages for you.
Disadvantages of interest-only home loans
Make sure you weigh these disadvantages carefully before taking out an interest-only home loan:
Repayment amount increases
When the interest-only period has ended, your monthly loan repayments may increase significantly. If you don’t plan for the jump in the repayment amount, this could negatively affect your finances.
Higher total interest payable
Usually, the interest rate for interest-only home loans is higher compared to a principal and interest home loan. This means that the interest you pay over the life of your loan will likely be significantly more compared to that on a principal and interest home loan.
Limited equity available
If the value of your home doesn't increase during the interest-only period, you aren't growing your home equity. This is because the repayments you're making aren't going towards the loan's principal, so the equity in the property remains the same.
Tips when transitioning from interest-only to principal and interest payments
If you do choose an interest-only home loan, it’s important to be prepared when the interest-only period ends. Here are some tips to help you manage the transition from interest-only to principal and interest repayments:
Develop a budget
To keep on top of your higher mortgage repayments, as well as your other financial obligations, it could be helpful to draw up a budget.
By doing so, you can account for your new mortgage repayments, any other mandatory payments, and see whether you need to cut back on recreational spending.
Create an emergency fund
Before the transition begins, it might be helpful to start up an emergency fund in case any out-of-the-blue expenses come up and throw off your budget.
This way, you won't be left stressing about what expenses you won't be able to cover, as there is spare cash sitting there for this very reason.
Gradually increase loan repayments
You could gradually start increasing your repayments if the lender allows it. This could help you to slowly get used to allocating more of your budget towards mortgage repayments.
Find a good interest-only home loan
It all starts with a good home loan. Finding one with a good rate and useful loan features can help you save money and own your home sooner. Check out our range of home loans to see which one best suits your needs.
If you'd like to know more about your interest-only home loan options, get in touch with one of our friendly lending specialists or apply online today!
Disclaimer: The information provided in this article is intended to be general in nature and does not constitute financial or legal advice. Please consider seeking your own professional advice tailored to your individual circumstances before making any financial or legal decisions.
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FAQs
What is the point of an interest-only loan?
The point of an interest-only loan is to reduce your regular mortgage repayments for an agreed-upon period of time.
This can be appealing for first home buyers, allowing them to manage their finances during the early stages of owning a home, as well as property investors looking to take advantage of tax benefits.
What are the risks of an interest-only mortgage?
The main risk associated with this type of loan is that you are unable to manage your regular mortgage repayments when the interest-only period term ends.
About the article
As Australia's leading online lender, loans.com.au has been helping people into their dream homes and cars for more than 10 years. Our content is written and reviewed by experienced financial experts. The information we provide is general in nature and does not take into account your personal objectives or needs. If you'd like to chat to one of our lending specialists about a home or car loan, contact us on Live Chat or by calling 13 10 90.
