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Interest-Only Home Loans
Written by
Kervin Mathew
Edited by
Ellie Garran
Reviewed by
Sam HymanWe’ve partnered with Aussie, who’ve helped 1.5 million Australians and counting
iSelect Mortgages Pty Ltd is a credit representative (Credit Representative 400540) of Lendi Group Distribution Pty Ltd (Australian Credit Licence 246786). iSelect Mortgages Pty Ltd receives a commission from Lendi Group Distribution Pty Ltd, the licensee for each new customer account created and for each home loan submitted through this service. Learn more.
What is an interest-only home loan?
If the name hasn’t already given it away, an interest-only loan is a home loan where you repay only the interest on the money you owe. You can do this for a set period, typically at the start of the loan term.
With lower monthly home loan repayments and extra cash in your pocket for other expenses, interest-only mortgages might sound like a dream. Are they the best bet for the long haul, though? Let’s dive into what they are, their benefits, and their drawbacks.
How do interest-only home loans work?
When you break the home loan down to its fundamentals, you have your principal and your interest.
- The principal is the sum that you owe on the property at any given time over the loan term.
- The interest is the ongoing cost of borrowing money from a lender.
Now, maybe it’s the fact that you’re yet to give them their money back, but lenders in Australia generally consider interest-only home loans as high risk and typically offset the risk with higher interest rates. Additionally, interest-only periods typically last five to 10 years. When the interest-only period ends, the loan usually switches to principal-and-interest repayments, unless you refinance or apply for a new loan arrangement.
The maximum total interest-only period also depends on whether you have an owner-occupied or an investment loan (like when you’re earning rental income from an investment property).
How could interest-only home loans be beneficial?
Despite its higher interest rates, here’s how you can use an interest-only home loan to your advantage.
To claim tax benefits
If you’re an investor, having an interest-only home loan could mean treating yourself to some sweet tax benefits. Interest payments on income-producing investment properties are generally tax deductible for property investors. So if you’re only paying interest, you can usually deduct the whole amount.
To free up cash flow
Maybe you’re looking at closing another debt, investing outside real estate – or you just want that air fryer your neighbour swears by! Your extra cash from not yet needing to repay your principal could help justify loosening up the purse strings.
To help short-term property investors
For investors who choose to treat real estate as a short-term investment, an interest-only home loan might make financial sense considering the lower repayments and accompanying tax benefits. However, if the housing market crashes, you can end up with negative equity.
To lower monthly repayments
Let’s say you absolutely must lock down that dream house, but you have a car loan or you’re saving up for holiday. There’s more room for affordability with an interest-only home loan and its lower monthly repayments.
To build equity more flexibly
While this feature isn’t about paying down your loan balance, it could still be of benefit. Some home loans (including some interest-only loans) come with an offset account linked to your mortgage. Money held in the offset account reduces the balance used to calculate interest, which can lower the interest you pay. Because the funds remain your own cash, you can withdraw them at any time if you need flexibility for things like investments or expenses.
What are some drawbacks of an interest-only home loan?
Higher repayments
No matter how well you prepare for it, you’re bound to feel the bill shock when your interest-only period ends, and the principal starts to feature in repayments.
Risk of negative equity
Real estate is certainly not risk free. If the housing market decides to crash and your property’s value ends up being less than what you borrowed to buy it, you’ll be left with negative equity.
Long-term loss
Because interest-only periods tend to come with higher interest rates and you’re not paying off the principal, you could be stuck in debt for a longer time.
Interest-only home loans explained
Learn the basics of interest-only home loans, the benefits, what to look out for, and how iSelect can ‘lend’ a helping hand.
How could interest-only home loans affect my repayments?
So, you’ve managed to snag that perfect home for $650,000 with a down payment of $50,000. For the remaining $600,000, let’s assume you take out a loan with a 30-year term and with a fixed rate of 6.2%.
Because you want to try and minimise the initial impact the repayments will have on your finances, you choose to go with interest-only repayments for the first five years of the loan term.
Take a look at the graph to see how your repayments might pan out.
And just so we’re on the same page with the terminology:
- principal – money you owe your lender at any time across the loan term
- interest – the cost of borrowing money calculated using the interest rate
- interest rate – the percentage rate at which interest is calculated
- interest-only repayments – loan repayments that cover only the interest
- loan term – the amount of time you have agreed to repay the loan amount over.
Note: The figures in the table were calculated based on an initial loan amount of $600,000 over a repayment period of 30 years.
Let’s take a closer look.
From years one to five, you end up paying a total of $37,200 a year. But because the payments are ‘interest only’, the principal remains the same – in other words, you haven’t started paying back the money you borrowed.
When your interest-only period ends, you’re likely to see a sudden jump in your repayments to make up for the initial interest-only ‘honeymoon’ period. Though the silver lining here is that once you start paying off the principal, the interest starts to decrease. That’s because you pay interest on the total outstanding loan amount.
Over the loan term, as the principal reduces, the interest charged generally reduces. Eventually your loan balance also goes down and you get to pay off your loan – which may at times seem like a fairy tale, and you get to live happily ever after in your castle.
Some savvy borrowers also make up for the interest-only ‘honeymoon’ period by making extra repayments (like when they receive a windfall or simply increasing the amount on a regular basis). If you want to see how paying a little extra could make a big difference, you can have a go at our extra mortgage repayments calculator.
Helpful tip
When you get to the end of your interest-only period, you’re not obligated to stick with your current lender. Your circumstances might have changed, or the markets as a whole might have shifted to lower interest rates. Be sure to shop around so you don’t miss out. You may be able to find a better deal and, who knows, if you show it to your current lender, they might be able to top it.
It’s also worth having a chat with your mortgage broker to see what the numbers could look like by switching.
Sam Hyman
General Manager – National Sales, Aussie
Frequently asked questions
What’s the difference between interest-only and principal and interest home loans?
The main difference comes down to what you’re actually paying off. During an interest-only term, you’re just covering the interest on your home loan – none of the actual loan balance. This means your repayments are lower for that period, but the balance doesn’t shrink. On the other hand, with principal and interest loans, you’re paying both the interest and the loan amount. That helps you reduce your debt faster and pay off the loan sooner.
Can I pay interest only on a fixed-rate home loan?
Yes, you can. Interest-only terms are available on fixed-rate loans, but there’s a catch: the interest-only term has to typically match the fixed-rate term. You can’t switch repayment types until the fixed rate period ends, in most cases break costs will apply. So, if you’re planning an interest-only setup, make sure it lines up with your fixed-rate term.
What are the rates for interest-only loans?
Given that it’s a high-risk offering from the lender’s perspective, an interest-only home loan could come with a higher interest rate than that of a regular home loan – sometimes around 0.5% higher for a variable-rate home loan.
Another factor could be your loan-to-value ratio (LVR), which is the percentage of a property’s value that you wish to borrow. Lenders use LVR to determine the risk level associated with lending to you.
If you’re not one for technical terms and the mathematics of it all, a lower LVR generally means lower interest rates.
It’s also worth considering the economic climate and the RBA’s cash rate. Both can influence lenders to either cut or hike interest rates for their financial products, home loans included.
Can I switch my existing home loan to interest only?
Making the switch from your current home loan to an interest-only home loan could give you some much-needed spending power, should your situation call for it.
It’s best to check with your lender or broker whether switching by refinancing is indeed an option. Keep in mind that you might need to satisfy some conditions, like meeting a minimum credit score.
It also depends on how far you are into the life of your loan. Typically, lenders might choose to remove the option of interest-only payments when you’re nearing the end.
How can I prepare myself for the end of the interest-only period?
If you’ve asked yourself this question while considering an interest-only home loan, good on you for thinking ahead.
Going back to principal-and-interest repayments needn’t be as shocking as it’s made out to be. Putting aside some cash as a financial buffer could work, as could setting expectations for a less flamboyant lifestyle once you make the switch.
Some lenders might also allow you to make sporadic repayments on the principal during the interest-only period. This could help when it’s time for principal and interest payments.
If you’re willing to shop around, and if luck is on your side, you might also be able to find a home loan package with a lower interest rate than what you initially signed up for.
Can I extend the interest-only period?
First, the good news. Yes, you sometimes can.
The not-so-good news: Interest-only periods come with a time limit.
Under current lending standards, owner-occupied loans are typically limited to five years of interest-only, and investor loans to 10 years in total.
Moreover, interest-only periods might only be available in whole years – meaning that you might not be approved for an interest-only period or extension that’s less than a year.
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iSelect is the trading name of iSelect Mortgages Pty Ltd (ABN 86 148 217 181). iSelect Mortgages Pty Ltd is a credit representative (Credit Representative 400540) of Lendi Group Distribution Pty Ltd (Australian Credit Licence 246786). iSelect provides a referral to Lendi Group Pty Ltd, a Credit Representative of Lendi Group Distribution Pty Ltd (Australian Credit License 246786). iSelect Mortgages Pty Ltd receives a commission from Lendi Group Distribution Pty Ltd, the licensee for each new customer account created and for each home loan submitted through this service.