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If you’re thinking about an interest-only home loan, it’s important to consider the pros and cons carefully. So, in this article we’ll explain how an interest-only loan works and then explore the advantages and disadvantages in detail. Let’s dive in.
With an interest-only home loan, you pay back just the interest charges on your loan for a set period of time, rather than paying back both the interest and principal (i.e. the loan balance). This interest-only period differs between lenders, but the maximum term is typically five years1.
The good news is that interest-only home loans initially give you short-term savings because your monthly repayments are typically lower. However, because interest is calculated on the principal of your home loan and you’re not reducing the principal during the interest-only period, you’ll likely be paying back more money over the life of the loan.
Traditionally, interest-only home loans have been popular among property investors who buy a property and then plan to sell it after a market cycle – typically seven to 10 years. They then pay off the balance of the loan and pocket any capital gains as sweet, sweet profit.
Another scenario might be someone building a home or doing major renovations and needing somewhere else to live in the meantime. In this case, an interest-only loan could make it easier for them to cover both rent and mortgage repayments.
Again, in both of these examples, an interest-only loan is best used strategically as it is not usually a long-term solution.
As we’ve established, interest-only home loans generally lower your monthly repayments. But they can also have other short-term benefits, like potential tax deductions. As with any financial decision, it pays to do your homework to fully understand the upsides and downsides. Here are some of the potential benefits1:
By only paying the interest on your home loan, rather than the interest and principal, your monthly repayments will generally be lower. But, as we’ll discuss in the downsides section below, you’ll need to remember that this is for a limited time.
If you’re an investor, an interest-only home loan could offer tax benefits. Investors may be able to claim tax deductions for interest paid on their property. If you have spare funds, you could consider opening an offset account attached to your interest-only loan to reduce your interest repayments.
When your interest repayments and property expenses outweigh your return, you are experiencing negative gearing. You may be able to claim these negatively geared expenses as a tax deduction.
If you’d like to obtain an interest-only home loan for tax purposes, speak to a tax accountant or financial professional to understand any implications involved. Having a well-structured home loan is important to make the most of these tax benefits.
Again, if you’re an investor, paying interest-only (with the interest being tax deductible) can free up extra cash for non-deductible purchases or other life expenses. Or maybe you could expand your ever-growing real estate empire.
You’ll notice that the list of disadvantages is longer than the list of advantages. That should reinforce the idea that interest-only home loans are something to consider very carefully and only if your circumstances would make it worthwhile. With that said, let’s take a look at the downsides:
Not all lenders offer interest-only loans, even if you’re an investor, so you may have to do a bit of searching to find one. It’s also likely that your application will be scrutinised very thoroughly to assess whether or not you’re a suitable candidate. So be prepared to jump through some hoops.
Unless you’re buying an investment property that you plan to sell within a few years, the day will come where you need to start paying off the principal of your loan. Most interest-only loans are only available for a few years, so when the loan switches to principal and interest repayments, the extra monthly cost can be a nasty surprise.
It doesn’t happen often, thankfully, but be aware that your property could lose value during the interest-only period of your loan. That would put you in the horrible position of owing more than the property is actually worth and ultimately you might have to sell for a loss.
Home loan interest rates are at a historical low (as of August 2020), so you actually have a great chance to make some real headway on your loan’s principal. And, because your interest is calculated on the principal, the more you can reduce the amount you owe, the less you may have to pay when interest rates rise again. But don’t count on rates staying low forever.
Having extra cash available is always nice, but it’s funny how quickly we get used to spending whatever money we have available. Unless you’re one of those incredibly disciplined people, you could find yourself overspending and setting yourself up for problems re-adjusting once you need to start paying off the principal amount as well.
If you decide to go ahead with an interest-only home loan, there is one golden rule: always keep your eye on how much your repayments are going to be at the end of the interest-only period. It’s vital to be certain that you can afford the higher repayments.
Remember that if interest rates rise, your loan repayments could go up even more. So, if your lender will let you make extra repayments, it could be a good idea to start making gradually higher repayments before the switch.
And finally, if you start feeling that you’re going to be in trouble once the loan switches to principal and interest repayment, speak to your lender early or seek out a financial counsellor to start making a plan.
At iSelect, we’ve partnered with Lendi to help you find a suitable home loan*. With Lendi you can compare a range of Australian home loan products, and select the one which suits you. Click here to get started today or give Lendi a call on 1300 186 260 (08:30-18:30).