Interest only Home Loan

Most home loans are principal-and-interest loans, which means that your regular payments will reduce the principal (amount borrowed) as well as paying off the interest. An interest-only mortgage is a home loan where only the interest is paid, rather than both the interest and the principle, and accounts for about 20% of mortgages in Australia.

This type of loan is popular for investors who are able to claim the interest they pay on the loan as a tax deduction, or buyers who only plan on holding onto a property for a few years before selling it. Interest-only home loans can be tempting to home buyers as the repayments are generally lower when no principle is included in the repayment, the major downside with these interest only home loans is that in the long term you may end up paying significantly more interest on your loan. As you are only repaying the interest on the loan the monthly repayments on interest only home loans will be lower than those of a standard home loan, though these lower repayments mean that you are not actually repaying any of the debt. Consequently at the end of the mortgage term you will still owe the lender the same amount that you originally borrowed.

Benefits of an interest-only home loan

Lower monthly repayments

For the interest only period of your home loan, which could be up to 10 years your monthly repayments will be comparatively lower, as you will only be the interest component of your loan. The example home loan below indicates the savings that can be made on your monthly repayment during the interest only period of your home loan.

 

  • Home Loan: $350,000
  • Home Loan Interest rate: 5.00%
  • Loan Term: 25 Years
  • Interest Free Term: 10 Years
  • Monthly Repayment during the Interest Only Period: $1,458
  • Monthly Repayment during the Principal & Interest Term: $2,768
  • Saving on monthly repayments during the Interest only period: $1,309

 

These lower monthly repayments can be attractive where you are currently working to a tight budget but have confidence that you will be in a stronger financial position in future years as your career progresses and income increases. Interest only loans are also popular with homebuyers who are buying properties that require some renovation, as the interest only period in the early years of the mortgage, enables you to divert your cash onto renovating your new home as opposed to repaying a higher monthly home loan repayment.

 

Tax Deductible Repayments

Under current tax legislation loans on investment properties are considered to be tax deductible debt, this means investors who select interest only home loans can claim a tax deduction of the full amount of their monthly home loan repayment, if they where to select a principal and interest home loan the interest on the loan would be less and as a consequence so would the amount they could claim as a tax deduction.

 

Disadvantages of interest-only home loans

Interest-only home loans are a great way of reducing your monthly repayments in the short term but the down side to this is that over the full term of the home loan they will cost you more than if you had selected to repay both the principle and interest on your home loan from day 1.

When you select an interest only home loan you are making the choice to not repay any of the money you have borrowed, this decision may help in the short term as you will have lower monthly repayments, but in the long term you will end pay significantly more interest over the life of the loan, compared to a principal and interest loan. In the example home loan above for $350,000 over 25 years with an interest rate of 5% you would pay $59,380 more in interest with an interest-only loan compared to a comparable principal and interest loan.

 

Increase in repayments after the interest-only period ends

At the end of the Interest Only Period of your home loan your repayments will rise reflecting the fact that your repayments now include a principle component in the repayment as well as the interest cost. This increase in monthly repayments can be significant so you will need to plan how you are going to meet these higher repayments, through either increasing your income or managing your expenses against this new level of expense.

 

You are not building equity in your home.

By choosing to repay only the interest component of your home loan for the first five to 10 years, you will not have repaid any of the principal amount of the loan and so not built up in equity in your home.

If your property does not increase in value during the interest-only period, you risk having no equity in your home at the end of this period, despite making payments every month. Holding no equity in your home puts you in a potentially risky position if there is a housing market downturn or your circumstances change and which result in you having to sell the property.

In conjunction with the Tax Deduction benefit interest only home loans remain popular with property investors as they believe their investment properties value will increase over the term of the interest only loan that means they will have generated equity in the property without repaying any of the principle loan amount. 

Frequently Asked Questions

What is a typical loan term for an interest-only home loan?

One to five years is a typical loan term for an interest-only loan, though periods upto 10 years are avaiable. At the end of the interest-only period, you must start making principal and interest repayments.

What is the difference between and Principal & Interest Home Loan and a Interest Only Home Loan?

Principal and Interest Home Loan repayments are made up of interest on the loan as well as some of the principal balance of the amount you borrowed. If you choose Interest Only, you will only be repaying the interest on the loan. You will not be reducing the loan amount that you borrowed. For example, if you have a $300,000 home loan as interest only for 5 years. You make the required monthly repayments and at the end of the 5 years, your loan balance is still $300,000 as you have only been repaying the interest. Interest Only is a popular option with property investors or if a borrower is wishing to enjoy lower home loan repayments for an intial fixed period, usually between 3 and 5 years.

What are the benefits of an Interest Only Home Loan?
  1. For property investors, interest only loans deliver reduced monthly expenses, which can free up additional cash-flow to make additional property investments. For example an investor may only be able to afford principal and interest repayments on two standard home loans, but could afford interest only repayments on three home loans.
  2. Interest payments on investment properties are fully tax deductable, whilst principal repayments are not tax deductible. By ensuring that the home loan balances never reduce, you will always be able to claim the maximum tax deduction on your home loans.
  3. Interest only loans will generally work to the advantage of the disciplined investor or people who are building or renovating their own home and have not stretched their borrowing power or loan to value ratio (LVR) to the breaking point.
  4. Interest Only Home Loans are a good option to help settle into making repayments on your mortgage in the intial years. Interest only loans are best to be considered for a term between five and ten years as this is the average time a home is occupied before re-financing and selling.  As with any investment, the larger the amount the more substantial the savings will be.  Therefore larger mortgages will receive the most savings benefits from an interest only loan.
What is an Interest Only Home Loan?

An Interest Only Home loan allows you to pay only the interest on the loan, rather than paying back both principal and interest. At the end of the interest only period, which is generally for between 5-10 years, you will still owe the full amount you originally borrowed. The primary advantage of interest only home loans is that the loan repayments are lower during this period. Interest Only Home loans are often favored by property investors who are planning to sell the investment property at the end of the interest only term, under the assumption that the property value will have increased during this period.