What is an interest only loan and how do they work?

What is an interest only loan and how do they work?
Interest-only home loans allow you to only pay the interest on the balance you have borrowed for a specific period. Find out more on how do interest-only loans work.
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If you're searching for a way to lower your mortgage repayments, you might have stumbled upon an interest-only loan.

An interest-only (IO) home loan is, in a nutshell, an agreement in which you are only required to pay interest on the amount you have borrowed for a set time period.

What is an interest-only home loan? 

Interest-only home loans involve making repayments that are only covering the interest on the amount you borrowed (the principal) for a set period of time. This is different from most other standard home loans in which you make interest payments as well as make regular repayments to reduce your overall loan balance. 

How do interest-only home loans work?

Interest-only home loans are usually only for a set period of time, e.g. for five years, and then the loan reverts to a principal-and-interest (P&I) home loan. During this five-year window, the repayment amounts are lower.

The difference between an interest-only loan and a principal and interest loan comes down to what the repayments are going towards.

When paying off an interest-only home loan, the repayment amounts are only covering the interest owed on the principal amount. 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 back to paying both principal and interest. This means that the amount you are contributing starts to pay off the principal, rather than just covering interest, which ultimately means higher repayment amounts (because you're paying for more).

To better illustrate the difference between an interest-only home loan and a principal-and-interest home loan , let's look at a hypothetical example.

The example on the left shows an interest-only period for five years and principal and interest for the remaining 25-years, and the example on the right shows a principal-and-interest loan for the full 30-years.

  Interest-only for first five years Principal and interest
Interest rate 2.50% 2.50%
Loan size $600,000 $600,000
Loan term 30-years 30-years
Monthly repayments during IO period $1,250 n/a
Monthly P&I repayments $2,692 $2,371
Total interest payable $283,110 $253,460
Extra interest paid due to IO period $29,650 $0

Pros of interest-only home loans

There are some notable pros of interest-only mortgages that might make them a suitable option for you.

Lower repayment amounts

Arguably, the biggest pro of an interest-only home loan is that the loan repayment amounts are lower. This can be helpful when you need some extra cash or you've experienced a period of less 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.

Investor benefits

There are also some potential tax benefits for using an interest-only home loan if you're investing in property. According to Moneysmart, you can claim higher tax deductions.

Additionally, with lower repayments, you will have access to extra cash flow to use on your investment property. you could choose to invest the cash you're saving on mortgage repayments elsewhere - whether that's into the home or into another investment type.

This could be helpful if you're going looking to sell the property within the interest-only period. If you made alterations that increased the home's value, or made extra money by investing elsewhere, you could pay off the entire mortgage once the property sells and still make a profit.

Cons of interest-only home loans

There are also some cons that need to be considered before taking out an interest-only home loan.

Cons of interest-only home loans

There are also some cons that need to be considered before taking out an interest-only home loan.

Repayment amount increases

While repayments will be less during the interest-only period, the monthly loan repayments will eventually go up, which can come as a shock to your budget and lifestyle.

As shown in the hypothetical example above, the monthly repayment amount goes up significantly, meaning you might need to account for this in your spending habits. As a borrower, it's important to factor in this jump in mortgage payments.

Higher total interest payable

Typically the interest rate is higher in market, which will result in an even higher total interest payable.

Limited equity available if home value doesn't increase Limited equity available

If the value of your home doesn't increase during the interest-only period, you aren't increasing 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.

When would an interest-only loan be beneficial?

Despite its benefits and drawbacks, there are two main situations in which an interest-only loan can be beneficial for homeowners: when you're trying to stay on top of other debts, and when you're an investor.

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 can be a useful way to keep mortgage repayments low. In this way, you have more capacity to pay off other debts, after which you can focus on keeping up with mortgage repayments.

Property investors seeking tax benefits

As mentioned, interest-only home loans have potential tax benefits for property investors looking to sell within the interest-only period. Using an interest-only home loan for an investment property allows you to make higher tax deductions and limit your investment costs.

How to transition from an interest-only to a principal and interest home loan

If the interest-only period is about to come to an end and you're dreading the inevitable increase in mortgage repayments, there are some things you can do to prepare yourself for this extra financial commitment.

1. 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.

2. 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.

3. Gradually increase loan repayments

Before the interest-only period ends, if your lender allows it, you could gradually start increasing your repayments. This will allow you to slowly get used to allocating more of your budget towards mortgage repayments.

4. Get a better home loan

You might be able to find a home loan with a lower interest rate which can make the shift less drastic, as you'll be paying a better rate. You can use a comparison website to compare loans, and either ask your current lender to match it or consider switching home loans.

It's important to consider all the costs involved in switching, and whether it works out cheaper.

5. Ask for help if you need it

If you're struggling to adapt to the new home loan repayments, there are free financial counsellors available to help negotiate with your lender.

Alternatively, you could reach out to your lender directly and let them know that you're struggling to adjust, and ask them to work out a financial hardship arrangement.

Who is eligible for interest-only loans?

Each individual lender will assess who is eligible for an interest-only home loan. In general, the lending criteria is similar to that of principal-and-interest home loans.

However, due to the increased risk involved with the interest-only period, they might have stricter credit requirements than their principal-and-interest home loan offerings. It will also depend on each individual borrower's personal and financial circumstances. 

If you're interested in applying for an interest-only home loan, get in touch with one of our friendly loans.com.au lending specialists today.

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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. 

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