Interest-only home loans

How to make interest-only home loans work for you.

Compare interest only home loans

If you’re shopping for a home loan, you’ve probably come across interest-only home loans. At first glance, they seem more affordable than standard home loans, so should you get one? Well, that depends on your circumstances, what you want to use the loan for, whether you’re an owner-occupier or an investor, and how long you intend to hold the property.

In this article, we’ll talk about how interest-only home loans work, who benefits from them, and the costs involved.

What is an interest-only home loan?

Most people are familiar with how standard mortgages work; you borrow a lump sum (the principal), and each month, you repay a portion of the principal plus the interest accrued. Over time, the principal becomes lower and lower until you pay the loan off.

With an interest-only home loan, you don’t pay back the principal for the first few years. Your repayments just cover the interest costs. For example, say you borrow $500K with an interest-only period of 5 years. Every month, for 5 years, you’d make interest repayments to the lender, but at the end of 5 years, you’d still owe them $500K.

How do I know if an interest-only home loan is right for me?

Interest-only home loans can be expensive in the long run, but they can be very useful for a few short-term situations. We’ve listed some of these below. If any of these circumstances apply to you, you may want to speak to your financial advisor about interest-only options.

Investment loans

If you’ve been shopping around, you’ve probably noticed that a large percentage of interest-only home loans that are available on the market are targeted towards investors. Here’s why:

  • Investors prefer short term loans. They don’t intend to keep the property long-term but instead hold it until the market goes up and they can sell it at a profit.
  • Because they are going to be selling the property, they are not focused on paying the principal and increasing their equity.
  • Interest-free mortgages keep repayments low, freeing up money to invest elsewhere.
  • There can also be substantial tax benefits involved.
 

Bridging loans

Bridging loans are used by people who are selling their old home to buy a new one. If the purchase of the new property goes through before the sale of the old property is finalised, they may find themselves trying to pay off two mortgages at once.

An interest-only bridging loan suspends principal payments on one or both of the mortgages so that the buyer only has to pay the interest. By reducing the repayments, a bridging loan can make the transition between home loans much more affordable.

Bridging loans normally have a maximum duration of 12 months, after which they convert to a regular principal-plus-interest loan. Most lenders will insist that you sell your old property in this time and pay off one of the loans so that you’re only left with one mortgage going forward.

Change in income

If you fall into financial hardship and you’re not able to meet your mortgage repayments, the lender may allow you to switch to an interest-only home loan. By reducing your repayments temporarily, you can avoid defaulting.

Some lenders will also allow you to switch to an interest-only home loan if you experience certain life changes – for example, if you go back to study or experience serious health issues – but only for a limited time.

Construction loans

If you are planning on building or renovating, you may be considering a construction loan. Construction loans, similar to investment loans, are designed to keep running costs low while construction takes place. They are typically interest-only for the duration of the build. The payments then revert back to principal-plus-interest once construction is complete.

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

Interest-only home loans can be useful short term-products. However, in the long run, they can be very expensive, which is why most lenders limit the interest-only period.

There are three main costs of an interest-only home loan that you wouldn’t pay on a regular principal-plus-interest loan:

  • Higher fees
  • Higher interest rates
  • Delayed principal repayment expenses
 

We go through these in more detail below and provide an example to get you started. However, if you are considering an interest-only home loan, it is critical that you take the time to crunch some numbers for yourself. Most lenders will have calculators on their websites to help you.

Delayed principal repayment expenses

We all know that the smaller your loan is, the less interest you’ll pay. If you have a principal-plus-interest repayment structure, then you are reducing your loan balance each month. Over time, as your balance gets lower, you pay less and less interest.

On the other hand, if you have an interest-only home loan, your balance stays the same, and so your interest payments don’t reduce.

The table below shows an example of a $500K loan to be paid back over 25 years, at an interest rate of 2.62%. You can see the difference between a standard principal-and-interest loan, and a loan where you pay interest-only for the first 5 years.

Interest-only Principal-and-interest
Monthly repayment (first 5 yrs)
$1,092
$2,273
Monthly repayment after interest-only period expires
$2,679
$2,273
Total interest paid
$208,422
$182,026

The interest-only loan starts off with monthly repayments of $1,092, which is much less than the repayments on a standard principal-and-interest loan of $2,273.

However, after the interest-only period expires, the repayments on the interest-only loan jump up to $2,679. You can think of this as playing catch-up. If you’re paying less at the start of the loan, you’ll need to pay more down the track to make up for it.

Most importantly, the total interest paid over the life of the interest-only loan adds up to around $26,400 more than the principal-and-interest loan.

Interest rates are higher for an interest-only home loan

In the example above, we assumed the interest-only loan and the principal-and-interest loan had the same interest rate. In reality, lenders charge a higher rate for interest-only loans. The most recent figures on the government’s Moneysmart website show that the average interest rate for a standard principal-and-interest home loan is 2.62%, while the average rate on an interest-only home loan is 3.28%.

So, let’s take the same example again; $500K paid over 25 years. This time, the interest-only loan has a rate of 3.28% for the first 5 years. After that, it reverts back to a standard loan with an interest rate of 2.62%.

Interest-only Principal-and-interest
Monthly repayment (first 5 yrs)
$1,367
$2,273
Monthly repayment after interest-only period expires
$2,679
$2,273
Total interest paid
$224,922
$182,026

As you can see, the interest-only repayments are $1,367 for the first five years, compared to the principal-plus-interest payments of $2,273.

However, after the interest-only period ends, the payments on the interest-only loan jump up to $2,679.

Overall, the interest-only loan works out to be $43K more expensive than the standard loan in the long run.

Higher fees

Lenders will have a different fee structure for interest-only home loans than they do for their standard interest-and-principal loans. Usually, interest-only home loans have higher fees.

How long an interest-only period can I have?

Interest-only periods are usually between 1 and 5 years. At the end of your first interest-only period, you can renegotiate with the lender to get a second interest-only period, for another 5 years. Most lenders will only renew your interest-only period once.

A few lenders take a more flexible approach. Instead of having set interest-only dates, they allow you to switch between interest-only and principal-plus-interest several times. However, they will still limit how much interest-only time you can accumulate over the life of your loan.

 If you are an investor, you may be offered a longer interest-only period of 10 or 15 years. These are generally not available to owner-occupiers.

The bottom line is that you should never look at fees and interest rates in isolation. They are both potential home loan costs. However, it’s important to understand that fees are potentially avoidable, interest isn’t.

Are interest-only rates fixed or variable?

Most lenders will offer both fixed and variable rates on an interest-only home loan. Some will also allow you to combine both of these in a split loan.

Fixed interest-only home loans

A fixed interest-only home loan has similar restrictions to any fixed loan. There may be fees for making early repayments, and withdrawals may be limited. It is important to note that your interest-only period and the fixed-interest period don’t need to be the same.

Variable interest-only home loans

A variable interest-only home loan, on the other hand, is much more flexible. They usually allow you to make early repayments and redraw excess funds. Some even offer offset accounts. However, since the interest rate keeps changing, your repayment amounts will change as well.

Am I eligible for an interest-only home loan?

The approval process for an interest-only home loan is similar to a standard home loan. You will be asked for details of your income, expenses, assets and liabilities. Your lender will also conduct a credit check. Generally speaking, lenders are stricter when assessing interest-only home loan applications because there is a higher risk of default.

Interest only home loans pros and cons

PROS

Free up cash

Free up cash for other purposes such as investing, or paying off other debts.

Extra repayments

Variable interest-only home loans allow you to make extra repayments without penalties. This means you can pay off the loan faster and save money on interest costs.

Tax benefits

Tax advantages for investors.

CONS

Lower equity

If you don’t make principal repayments, your equity won’t grow, and you may find it difficult to refinance in the future.

More expensive

More expensive than a principal-plus-interest loan in the long run.

Higher repayments

Payments can jump up quite a bit once the interest-only period is over.

When your interest-only period is up, your repayments can increase drastically. Make sure you budget for this. If you can, try gradually increasing your repayments before the interest-only period expires, so that the jump in repayments is less of a shock to your finances.