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What is an interest only home loan?
Home loan repayments are based on paying off two factors: the principal (loan amount owing) and the interest (rate set by the lender charged on the principal).
Most home loan repayments in Australia are designed to pay both the principal and interest each time. However, some lenders do allow homeowners the option of paying just the interest with their repayments, also known as an interest only home loan. By only paying for the interest charges on your home loan, your repayments are significantly reduced.
Home loans with interest only repayments are typically set to revert to principal and interest repayments after a few years. This is because by only repaying interest charges, you’re not actually chipping away at your principal owing - meaning, your home loan debt is never actually being repaid.
How does an interest only home loan work?
Home loan terms are typically 25-30 years, and for however long you pay interest-only, you’re not actually reducing your principal owing. For a borrower that doesn’t sell a property for profit quickly, this means that eventually when your interest-only period ends, your repayments will be significantly higher.
This is because you’ve effectively just shortened your home loan term without reducing your debt.
For example, let’s take a 30-year, $350,000 home loan at a rate of 3%. If you were making principal and interest repayments, your monthly repayments would sit at $1,476. If you were paying interest only over a 5-year period, your monthly repayments would be $875. This is a savings, albeit short-term, of $601 a month.
Principal and interest vs. interest only home loan repayments comparison
Principle & Interest | Interest-only for 5 years | |
---|---|---|
Monthly repayments during interest only period | $1,476 | $875 |
Monthly repayments after interest only period | $1,476 | $1,660 |
Total repayments made | $531,221 | $550,422 |
Additional interest paid due to the interest-only period | / | $19,201 |
Source: RateCity.com.au.
Note: Based on a hypothetical 30-year, $350,000 home loan at a rate of 3%. Figures used for example purposes only and do not factor in rate changes or fees.
While the interest-only period may offer some short-term savings, it often leads to higher payments afterward. In the example, at the end of the interest-only period, monthly repayments increase to $1,660, which is $184 more than the standard principal and interest repayments. Over a year, this amounts to an additional $2,208 in mortgage repayments – roughly equivalent to a yearly utilities bill or a family holiday.
Here are some key points about interest-only home loans:
- Owner-occupiers: For those living in the property they have purchased, the interest-only period typically ranges from one to five years.
- Investment properties: For investors, the interest-only period can be longer, often extending up to 10 years.
- After the interest-only period: Once the interest-only period ends, your loan will revert to principal and interest repayments. This means your monthly repayments will increase as you start paying down the principal amount borrowed in addition to the interest. It’s crucial to plan for this transition to ensure you can afford the higher repayments.
If you’re considering an interest-only home loan, it’s important to plan ahead and prepare for the increased repayments once you come off the interest-only period. Using an interest-only loan for a long duration may not be the best strategy for everyone, as your total debt is not reduced during this period. It is important to have a clear plan for transitioning to principal and interest repayments to ensure you’re eventually paying down the debt.
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Who might choose an interest only home loan?
Interest only repayments are lower than principal and interest repayments, so they are often favoured by borrowers hoping to keep expenses down, typically investors looking to flip a property.
If you are an investor unlikely to keep a property for the full 25-30-year home loan term, then interest only repayments may be an option to consider. If principal and interest repayments on an investment property were, say, $2,000, but paying interest-only meant your monthly repayments were a few hundred dollars, your rate of return when you sell may be significantly higher.
Owner-occupiers may also be able to opt for interest only repayments. However, since owner-occupiers typically live in the home for the duration of the loan term, it might be more beneficial to focus on repaying the principal amount. Nonetheless, if a homeowner falls into financial stress and struggles with mortgage repayments, refinancing to an interest-only home loan may offer some financial relief.
Just keep in mind that for however long your repayments are set to interest only, you are not paying down your mortgage debt. When the interest only period ends, you may find your repayments are higher than before due to your shortened loan term.
What are the benefits and drawbacks of interest only loans?
Before you choose your home loan repayment type, it’s worth comparing the benefits and risks of interest only repayments.
Potential benefits of interest only loans:
Interest-only loans can provide various benefits to borrowers, depending on their specific situations and financial goals.
- Lower repayments – The most significant benefit of interest only repayments are that it offers borrowers lower monthly repayments during the interest only period.
- Higher rate of return – If you’re a property investor, opting for interest only repayments may offer you a higher rate of return on the property by reducing your ongoing mortgage expenses.
- Free up cash – For owner-occupiers and investors alike, paying lower mortgage repayments may help free up some much-needed cash for other purposes.
Potential risks/drawbacks of interest only loans:
As with any financial product, there are risks worth considering when it comes to interest only home loan repayments.
- Higher ongoing repayments – As demonstrated above, once your interest only period ends, your repayments will increase considerably.
- Pay more interest – By not repaying your loan principal owing for several years, you may pay additional interest over the life of the loan.
- Risk of default – In 2017, the Australian Prudential Regulation Authority (APRA) ordered banks to reduce the number of interest only loans on their books to below 30%. This is because a considerable portion were interest only, meanwhile debts were not being repaid and borrowers were struggling with higher repayments once this interest only period ended. There is always a risk with interest only repayments that you may be unable to service the loan once this period ends and/or if your financial circumstances change.
Can I change my home loan to interest only?
If you are unhappy with your home loan and want to switch to interest only repayments, you may have two options: speak to your current lender and/or consider refinancing.
Regardless of the path you take, you may need to meet certain eligibility criteria as you did when you first applied for the mortgage. This may include having an LVR of 80% or less, having good to excellent credit history and in a strong financial position.
Switching to principal and interest repayments after an interest-only loan
One of the biggest risks with interest-only loans is the increase in repayments when the loan reverts to principal and interest at the end of the interest-only period. In some cases, the repayment amount will increase significantly, which can cause substantial financial strain if you’re not prepared for it.
To minimise the financial impact of this transition on your budget, it can help to prepare in advance by knowing when your repayment will increase and by how much. Building a savings buffer during the interest-only period could help reduce the pressure when your loan reverts to principal and interest repayments, especially if you plan to use an offset account to lower your interest.
Talk to your lender and ask for support in advance of the switch if you can’t afford the repayment increase. Depending on your needs, you may consider extending your interest-only period if that’s an option, or explore refinancing your home loan with another lender if you find a better deal and are eligible.
How do I compare interest only loans?
One of the best ways to compare home loans is to use comparison tools, such as tables, calculators, and rating systems. At RateCity, we offer the following:
Comparison tables
Comparison tables, like the one on this page, may help you filter down your home loan options then compare them side by side. Sort your results by advertised rate, comparison rate or Real Time Ratings™ score, and create a shortlist of options that may suit your financial situation.
Home Loan Repayment Calculator
A Home Loan Repayment Calculator will calculate potential mortgage repayments based on different interest rates and repayment frequencies. This may help you to view how an interest only home loan’s repayments could suit your budget, allowing you to narrow down your options.
Real Time Ratings™
To narrow down your shortlist of options, you may want to look at the Real Time Ratings™ score of each loan product. Real Time Ratings™ is RateCity’s world-first rating system that ranks home loans based on your individual requirements. Each product is given a score out of five, based on loan costs and flexibility. Unlike other comparison pages which rank their products once or twice a year, Real Time Ratings™ results are calculated live, so they are up to date as possible.
Mortgage Brokers
As interest only home loans may be more difficult to find, it may be worth speaking to a mortgage broker for expert advice and assistance finding your best loan option and filling out your loan application – without charge.
What are the features of interest only loans?
Who offers interest only loans?
You may be able to apply for an interest only home loan from a range of Australian lenders, including the big four banks (Commonwealth Bank, Westpac, ANZ and NAB), as well as lenders like Bank Australia, Macquarie Bank and loans.com.au.
If you have an ideal lender in mind for your interest only home loan, click on more filters above the home loan comparison table, find the lender’s field and enter its name here. You’ll potentially be shown one or more interest only home loan rates from that lender.
Applying for an interest-only home loan
Applying for an interest-only loan is typically the same as applying for any home loan, but getting approved for one may be more challenging. This is because lenders view interest-only loans as riskier compared to principal and interest home loans.
To increase your chances of approval, consider having a deposit of 20% or more. You should also clearly explain why you prefer an interest-only loan, which may help the lender understand your situation better.
While you can go through this process on your own, you may consider seeking help from a mortgage broker, which could improve your chances of approval. A broker can guide you through the application process, help you gather the necessary documentation, and present your case in the best possible light to potential lenders. Additionally, brokers often have access to a wider range of loan products and may be able to find a lender that is more understanding of your situation and requirements.
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