3 benefits of interest-only loans
Interest-only loans are perfect for two types of property buyers: investors and first-home...
08 Apr, 2021
Base criteria of: a $400,000 loan amount, variable, fixed, principal and interest (P&I) & interest only (IO) home loans with an LVR (loan-to-value) ratio of at least 80%. However, the ‘Compare Home Loans’ table allows for calculations to be made on variables as selected and input by the user. Some products will be marked as promoted, featured or sponsored and may appear prominently in the tables regardless of their attributes. All products will list the LVR with the product and rate which are clearly published on the product provider’s website. Monthly repayments, once the base criteria are altered by the user, will be based on the selected products’ advertised rates and determined by the loan amount, repayment type, loan term and LVR as input by the user/you. *The Comparison rate is based on a $150,000 loan over 25 years. Warning: this comparison rate is true only for this example and may not include all fees and charges. Different terms, fees or other loan amounts might result in a different comparison rate. Rates correct as of February 21, 2023.
What is an interest-only home loan?
A typical home loan repayment consists of two parts:
- The principal - the amount you borrow
- The interest - the amount a lender will charge you on your outstanding balance
With an interest-only home loan, mortgage holders are only required to pay off the ‘interest’ part of the loan, rather than the principal and interest (P&I) for an agreed period of time, usually between three to five years.
For some borrowers, having an interest-only home loan is a suitable way to ease themselves into the loan by making the bare minimum repayments. What this means is that your home loan balance won’t reduce during the interest-only period since you’re technically not paying off the amount you borrowed. Additionally, interest rates for interest-only home loans tend to be higher than P&I home loans.
If you’re considering an interest-only loan, you’ll want to do some research to find out all the elements involved and ultimately whether it’ll suit your needs and circumstances.
What happens when an interest-only loan expires?
Like anything, an interest-only home loan doesn’t last forever.
When the time comes, your interest-only loan will automatically roll over to P&I repayments. This means you’ll start paying off the amount you borrowed as well as the interest.
There are three options you can follow if your interest-only loan period is ending.
1. Extend the interest-only period: If possible, your lender may be willing to extend your interest-only period to keep you as a customer.
2. Get ready for P&I repayments: If you’re ready to make the switch to P&I repayments, ride out the expiry of the interest-only period and settle into P&I repayments with no hassles.
3. Refinance: Maybe you’ve done some research and seen a better rate on the market. If so, you might want to look at refinancing your home loan with your current lender or a potential new one to take advantage of any beneficial features.
How long can you take out an interest-only loan for?
On average, lenders offer interest-only periods between three to five years. However, if you have a chat with your lender, they may be able to offer you up to 15 years but this is generally reserved for investors.
What are the benefits and disadvantages of an interest-only home loan?
No matter what type of home loan you decide to take out, it’s always a good option to weigh up the pros and cons involved. Below is a list of some of the benefits and risks you could encounter when taking out an interest-only home loan.
The advantages of interest-only home loans
- Lower repayments: The lower initial payments of an interest-only loan can make it easier for borrowers to save more, pay off outstanding debts, or purchase a property sooner. Interest-only loans also benefit buyers who are experiencing financial hardship or a temporary reduction of income. This is possibly the biggest appeal for interest-only loans.
- Tax incentives for investors: If you’re an investor, you could claim higher tax deductions from an investment property. According to the ATO, investors can “claim a deduction for the interest charged on the loan or a portion of the interest.”
The disadvantages of interest-only home loans
- The repayments will eventually go up: An interest-only loan can only last for so long so you need to be confident that you can manage P&I repayments when the loan expires.
- Higher interest costs: You end up paying more in interest over the life of your loan than you would with a P&I loan. To explain this further, with a P&I loan, as the principal amount decreases, so too does the amount of interest being charged.
- Generally higher interest rates: When you’re conducting research on an interest-only home loan, you may notice that they generally have a higher rate of interest compared to a P&I loan.
- Less equity buildup: With an interest-only loan, you may not be building any equity in your property. If the value of your property was to possibly fall, you could end up owing more to the lender than what the property could sell for if you had to sell for any reason
Interest-only vs principal and interest
To show you the difference between the two payment types, we’re going to compare how much interest a mortgage borrower would pay for an interest-only loan versus a principal and interest loan.
For example, John Smith decides to take out a home loan of $500,000 for 30 years.
For the purpose of this comparison, it’s assumed John’s interest rate is 3.00% p.a which holds steady over the 30 years for both the interest-only loan and the P&I loan.
For the interest-only loan, John opts to pay this for five years before switching to P&I for the remaining 25 years.
|
John Smith (P&I) |
$500,000 |
N/A |
$2,108 |
$758,887 |
|
John Smith (Interest-only) |
$500,000 |
$1,250 |
$2,371 |
$786,317 |
|
Total cost difference |
N/A |
N/A |
$263 |
$27,430 |
As shown above, by paying an interest-only loan for the first five years, John’s loan will cost him over $27,000 more than the P&I loan over the 30 years.
How to compare interest-only loans
Generally, lenders tend to charge higher interest rates on interest-only home loans compared to P&I loans.
If you’re unsure whether an interest-only loan or principal and interest loan will work best for you, compare the interest rates that are available on the market with both payment types.
To get you started, check out our handy comparison table above with some of the best interest-only loans on the market. Or, insert all the relevant information (loan amount, loan term, payment type) into our mortgage repayment calculator to find out your estimated repayments, the total principal paid, and the total interest paid. From there, you can make a decision regarding whether interest-only or principal and interest repayments are the right option for you.
Frequently Asked Questions
Find answers to the most frequently asked questions about interest-only home loans.
Lenders usually require a 20% home loan deposit for interest-only loans. While borrowers can opt to apply for an interest-only loan with a higher loan-to-value ratio (LVR), the approval will ultimately depend on the assessment of the lender.
If you are approved with a less than 20% deposit, your home loan provider will likely charge you with Lenders Mortgage Insurance (LMI).
Yes, it’s possible to make extra repayments on an interest-only home loan. Additional payments on top of your monthly repayments during the interest-only period will reduce the principal amount of your home loan.
When an interest-only period ends, the loan will automatically roll over to principal and interest repayments, which means higher monthly repayments. It is possible to ask the lender to extend the interest-only period. Another option is to refinance. This will lower the monthly repayments and provide an opportunity to take advantage of other loan features.
An interest-only period usually lasts up to a maximum of five years for most lenders, given the high level of risk interest-only home loans carry. The length of the interest-only period can be arranged with the lender.
An interest-only home loan is a special arrangement where the borrower is only required to pay for the interest part of the loan for a certain period. This means that during the interest-only period, any repayments made will go directly to the interest portion of the loan while the principal (the amount borrowed ) remains untouched.
Interest-only home loans can help borrowers ease into the regular mortgage repayments by providing a couple of years of lower monthly repayments. Given the tax deductibility of interest costs, investors usually opt for interest-only loans when applying for a loan for their investment properties.
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