Alan Hartstein
Georgia Rose
Athena Cocoves
An interest-only home loan is a type of home loan that requires only the interest to be paid back for a set period of time, such as the first five years. This is in contrast to the standard principal-and-interest home loans that require you to pay both the interest and the principal throughout the entire term of the loan.
The interest-only portion of the loan typically occurs during the start of a mortgage, but it is possible to revert to an interest-only loan during future periods.
The initial payments for interest-only home loans are typically lower than standard loans, which can make them appealing to first-time home buyers who want to keep their expenses down. But the jump to paying both interest and principal after the interest-only period is up can be jarring for some.
How do ‘interest-only home loans’ work?
Interest-only home loans allow you to pay just the interest for a set period of time, typically the first few years of the loan. After this period ends, you pay both the interest and the principal:
- the principal is the amount you borrow from your lender
- the interest is what the lender charges for borrowing the principal amount.
Here’s an example of how an interest-only home loan could be set up:
- loan amount (principal): $500,000
- interest rate: 5.95%
- loan term length: 25 years
- interest-only period: First five years.
During the interest-only period on the above loan, your monthly payments would be $2,489*.
Once that period ends, those payments would increase to $3,578 — which includes both the interest and the principal.
This method of putting off principal repayments can be helpful in the short term, but it tends to cost more over time when compared to a standard interest-and-principal loan. In the above example, the interest-only loan costs roughly $43,000 more than if you paid both the interest and the principal from the start.
*Assuming a $10 monthly fee and the same rate throughout the entire loan. This calculation is based on the Moneysmart interest-only calculator.
Interest-only vs fixed interest rate
A fixed-interest rate home loan locks in the interest rate for a set time, such as the first five years. After which, the interest rate is variable — meaning it fluctuates with the market.
You can get an interest-only home loan with a fixed rate period. The fixed-rate period is typically the same length of the interest-only period.
» MORE: How are interest rates determined?
Pros and cons of interest-only home loans
Finding the right type of loan may seem like walking through a minefield, especially if you’re a first-home buyer. It’s important to understand the pros and cons of interest-only home loans, and who they’re geared towards before you sign on the dotted line.
Pros
- Payments are lower. Your fortnightly or monthly payments are lower during the interest-only period because you’re not repaying the principal yet.
- Available through the length of the loan. Interest-only periods can be applied at different times of your loan, so you can lower payments if your financial situation suddenly changes. Check with your prospective lender to see what flexibility they offer.
- Investors get tax benefits. You might be able to claim taxation advantages for interest-only loans that can maximise your property investment. You should always talk to a mortgage expert or accountant about effectively offsetting your interest payments.
Cons:
- Higher interest rates. Interest-only loans typically have higher interest rates than standard home loans. A higher interest rate at the outset equates to a lot of extra money over the course of your mortgage.
- Debt doesn’t decrease. Only paying the interest means you’re not paying down your debt (the principal). As a result, you’ll spend more throughout the mortgage compared to a loan that covers both principal and interest from the start. If the property decreases in value over the interest-only period and interest rates go up, you could find yourself underwater — owing more than the property can sell for.
- No equity. During the interest-only period, you won’t be building any equity in the home. You’ll just be paying the interest.
- Repayments will increase. There are limits to how long you can hold an interest-only mortgage. When the period is up, you have to pay both interest and principal, resulting in a higher payment. Be prepared for this shift so the increased cost doesn’t break the bank or cause mortgage stress.
🤓 Nerdy Tip
During the interest-only period, it’s a good idea to put aside a little money each month — in a savings account, for example. When the interest-only period ends and the repayments increase, you’ll hopefully be used to paying the extra amount, and will have a small savings to help cover the increase as you adjust.
‘Interest only home loan’ calculator
You can use the government’s Moneysmart interest-only mortgage calculator to figure out how much your repayments will be.
Before deciding on an interest-only loan, shop around for the best possible deals, especially regarding interest rates. There’s plenty of competition in the marketplace. Focus on finding a compelling deal that best suits your situation and finances.
DIVE EVEN DEEPER
What is Principal and Interest on a Home Loan?
Principal is the amount of money borrowed from a lender; interest is the extra amount charged by lenders in exchange for using their funds.
Should I Refinance My Home Loan?
You should consider refinancing your home loan when the new loan offers a lower interest rate with better terms.
How Does Inflation Affect Interest Rates in Australia?
Interest rates and inflation are deeply intertwined. Here’s how they affect each other, and your finances.
Should You Switch Your Home Loan?
Before switching, however, you should ask yourself what you want to achieve. Also, take a bit of extra time to shop around for the best possible deal.