One of the most significant choices you’ll have to make when choosing a home loan is whether you want your repayments to be on a principal and interest basis or an interest-only basis.
Let’s explore how the interest-only home loan repayments work, and which repayment option may best suit your financial needs and property goals.
Different mortgage repayment types explained
Your home loan repayments will be composed of two main factors – paying back the ‘principal’ or the loan amount, and the interest charges on top of this.
However, some homeowners can opt to only repay just the interest on their monthly mortgage bill for a fixed period.
Principal and interest repayments refers to paying both the principal and interest charges. For example, on a 25-year $400,000 home loan with a rate of 2.5%, monthly repayments would be $1,794.
Interest-only repayments refers to paying just the interest charged on your ongoing repayment. On this same hypothetical home loan with an interest-only period of 5 years, your monthly repayments would instead be $833. After this period ended, the repayments may then revert to principal and interest, with the new monthly repayments now at $2,120.
As you can see, opting for interest-only repayments may allow for a much smaller ongoing repayment for the interest-only period. However, in that time the loan amount has not reduced, just the loan term (25 years to 20 years).
Interest-only repayments on $400,000 home loan
Note: figures based on hypothetical 25-year, $400k home loan at interest rate of 2.5% with interest-only period of first 5 years. Does not factor in fees or rate fluctuations.
Principal and interest repayments on $400,000 home loan
Note: figures based on hypothetical 25-year, $400k home loan at interest rate of 2.5%. Does not factor in fees or rate fluctuations.
By opting for an interest-only mortgage for five years of a 25-year home loan, you may pay $20,367 more than if you paid principal and interest. But your initial payments are kept at a rock-bottom price.
What are the advantages of interest-only repayments?
You may be wondering what kind of borrower would purposely pay more over the life of a loan if the above were the potential price difference.
Interest-only home loan repayments are typically more coveted by investors as it helps to minimise the initial expenses and increase the return on investment when sold. This can be particularly useful if an investor is selling before the home loan switches to principal and interest repayments. Further, the interest charges on an investment mortgage may be tax deductible.
Owner-occupiers may choose to opt for interest-only repayments if they’re looking to reduce expenses in their household budget, especially if paying for the home loan deposit significantly reduces their savings.
It may also be useful in situations of financial stress to switch to interest-only repayments, such as injury, illness, job loss etc., where a borrower is unable to earn their regular income.
However, owner-occupiers are more likely than investors to stay living in the home they own rather than sell over a 25-30-year home loan term. Meaning, once the time comes to repay the principal owing, the repayments may be considerably higher (as demonstrated above)
Benefits of interest-only:
- More affordable repayments
- Reduces initial expense
- Can be tax deductible (if property investor)
Disadvantages of interest-only:
- Not chipping away at principal, so if payments revert to principal and interest, repayments are significantly higher.
If you’re still unsure which repayment option may best suit your financial situation and budget, it may be worth speaking to a broker for personal advice.