An interest-only home loan, as the name suggests, is a type of home loan where you are only required to pay back the interest portion of your loan amount for a particular period of time. This is in contrast to the standard principal and interest loan. Interest-only loans are usually only taken out for the first five years of a mortgage, but it is possible to revert to an interest-only loan for other periods if you want to at some point in the future.
An interest-only mortgage is one option for first-time home buyers. It’s mainly used as an investment vehicle for those wishing to grow their wealth by paying less in repayments over the first years of their mortgage so they can reinvest their savings elsewhere for a hopefully greater reward.
Difference between principal and interest-only home loans
With a principal-and-interest loan, the borrower makes regular monthly payments to amortise the debt over time. The borrower owns the property outright, with no further balance due at the end of the agreed-upon term.
Principal is the amount you borrow from your lender. A standard mortgage consists of the principal and the interest rate payable on that principal, which is how the lender makes its money off the loan. The standard variable interest rate usually determines the interest rate calculated on the loan at the time and runs slightly higher. Your lender may offer you a fixed interest rate or honeymoon interest rate for up to the first five years of your loan.
Rather, with an interest-only loan, you may borrow $500,000 over a 30-year term at 5.37% with an interest-only component for the first five years. At the end of that introductory period, the loan reverts to a standard principal-and-interest loan, increasing the monthly payment. For the interest-only period, the repayments are much less than if you were paying off a principal-and-interest mortgage.
In the above example, the monthly repayments for the interest-free period would be $2248. After the interest-only period ends, however, the loan repayments become $3042. That’s nearly $800 higher than your previous commitment because you now only have 25 years to repay the loan’s principal in full.
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. Interest-free home loans are an option, but it’s important to understand the pros and cons and who interest-only loans are really geared towards in the property market.
- Repayments are lower. Your fortnightly or monthly repayments are lower because you’re not repaying the principal yet.
- Possibility of switching between options. Interest-only home loans are not just available at the outset of your mortgage. You may be able to switch between paying interest-only and principal-and-interest. Check with your prospective lender to see what flexibility they offer in this regard.
- Investors get tax benefits. There are taxation advantages for interest-only loans that can maximise your investment. However, much of the law is complicated. So, you should always talk to a mortgage expert or accountant about effectively offsetting your interest payments against rental income.
- Higher interest rates. A higher interest rate at the outset equates to a lot of extra money over the course of your mortgage. On top of paying a higher rate, you start from scratch on the principal debt when the interest-only period ends.
- Debt doesn’t decrease. Making the minimum required repayments that only cover the interest charged means not a cent is paid off the amount you borrowed right up until the end of the interest-free period. If the property doesn’t increase in value over the interest-only period and the market tanks, you could find yourself underwater — owing more than the property can sell for.
- Repayments will increase. There are limits to how long you can hold an interest-only mortgage. That means you must be prepared for a shift in your investment strategy in the middle of your mortgage. It also means you may be totally unprepared for the rise in your regular repayments and struggle to adjust.
Deciding on an interest-only loan
Interest-only loans are available to homebuyers under certain conditions, yet the risks may outweigh the benefits and generally appeal more to investors. The more steadily you pay off your mortgage, the greater the chance of building wealth and increasing equity in your asset.
At the very least, you should have a lengthy discussion with an accountant or mortgage expert to ensure that it is the right course of action for you. Once you’ve made that decision, check with your lender. See your repayments at the end of the interest-only period and if your sums to ensure you can afford it. You may want to factor in some breathing room when doing your calculations — especially given the state of interest rates and the possibility of them rising again.
Finally, have a 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.
Home loan repayments are calculated based on how long the loan lasts, your interest rate and whether you’ll repay just the interest to start, or both the principal and interest. You can use a home loan repayment calculator to estimate your payments.
Knowing whether or not to fix your home loan for a set period of time or to take on the relative risk of a variable rate is one of the major challenges that will confront you as a first-time home buyer.