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Compare interest only home loans

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The ins and outs of interest-only loans

People sign up for interest-only loans because they allow you to lower your repayments during the interest-only period. 

However, these initial savings come at a cost – literally. 

First, you’ll have to accept higher repayments once the interest-only period ends. Secondly, you’ll have to pay more over the life of the mortgage. 

That’s why you should think carefully before taking out this sort of loan. 

It sounds obvious, but you should only choose an interest-only loan over a principal-and-interest loan if you’re convinced the short-term gains will exceed the long-term costs. The key, though, is to actually do your sums. 

For more information on interest-only loans, read the FAQ below. 

What are interest-only loans?

Most mortgages are principal-and-interest loans, which require borrowers to simultaneously pay interest and pay down their principal. 

However, with interest-only loans, borrowers only pay interest, which means their principal doesn’t get reduced. 

For example, imagine you wanted to buy a $440,000 property. You might borrow $350,000 at an interest rate of 5 per cent, with the mortgage spread over 30 years and repayments scheduled for each month. 

If you had a principal-and-interest loan, you would have to pay $1,889 per month – $1,468 of that would be interest, while the other $421 would go towards reducing the principal. (So, after one month, your mortgage would be reduced from $350,000 to $349,579. After two months, it would be reduced to $349,158.) 

If you had an interest-only loan, you would have to pay just $1,468 per month. This would be nothing but interest, so your outstanding mortgage would remain at $350,000. 

Generally, interest-only loans last for five years, at which point the loan automatically reverts to a principal-and-interest loan (although some lenders will allow you to extend the interest-only period). 

In the example above, you would now be left with 25 years to repay your $350,000 mortgage, which would require monthly repayments of $2,056. 

If you did five years of interest-only followed by 25 years of principal-and-interest, your total cost would be $704,920. If you did 30 years of principal-and-interest, your total cost would be $679,995 – a difference of $24,924. 

What are the pros of interest-only loans?

Clearly, people take out interest-only loans so they can reduce their repayments during the interest-only period. But the real point of interest-only loans is not so much to save money but to use this money to do something else. 

In the example above, you’d be left with an extra $421 in your pocket each month. Here are three ways you could use that extra money to your advantage: 

  1. Enter the market ahead of schedule

If you were a young first home buyer, you might not be able to afford to buy your hypothetical $440,000 property if you had to pay $1,889 per month. However, you might be able to afford it if you only had to repay $1,468 per month for the first five years. 

Sure, you’d have to pay an extra $24,924 over the life of the mortgage. But if you held off entering the market until you had enough money to afford a principal-and-interest loan, your property might end up costing you an extra $30,000 or $40,000. 

Also, by the time your mortgage reverts to principal-and-interest, your salary is likely to be higher, which would hopefully mean that you could now afford the increased repayments. 

WARNING: This strategy could backfire if your property doesn’t increase in value during the five-year period or if you can’t afford the higher repayments once it ends. 

  1. Buy an investment property ahead of schedule

Imagine that you used an interest-only loan to enter the market ahead of schedule – but this time with an investment property. And imagine the value of this investment increased by 10 per cent during the interest-only period. 

In that case, your property’s value would climb from $440,000 to $484,000 – so you’d pay an extra $24,924 in repayments to gain an extra $44,000 in equity. 

Also, if your investment property was negatively geared, you’d be able to use some of the interest payments to reduce your taxable income. 

WARNING: This strategy could backfire if your property doesn’t increase in value during the five-year period or if you can’t afford the higher repayments once it ends. 

  1. Repay higher-interest debt

Starting your mortgage with an interest-only term could be smart if you also had to repay other debts that were priced higher than the 5 per cent being charged for your mortgage. 

For example, you could use the extra $421 per month to pay off a car loan (at, say, 8 per cent), a personal loan (12 per cent) or a credit card debt (15 per cent). 

WARNING: This strategy could backfire if you didn’t use the extra money to repay the other debts or if you couldn’t afford the higher repayments once your interest-only period ended. 

What are the cons of interest-only loans?

There are two big disadvantages with interest-only loans. First, your mortgage doesn’t decrease during the interest-only period. Second, you end up paying more over the life of the mortgage. 

The other disadvantage is that the repayments you will be charged once you move from interest-only to principal-and-interest will be higher than if you’d been on principal-and-interest all along. That could cause problems if your financial position hadn’t improved during the interest-only period. 

What's an example of an interest-only mortgage?

Let’s take the example quoted above – a 30-year mortgage worth $350,000 with monthly repayments and an interest rate of 5 per cent. 

The table below shows what would happen if the mortgage functioned as a principal-and-interest loan for the entire 30 years. 

It also shows what would happen if you went interest-only for five, 10 or 15 of the 30 years, before switching to principal-and-interest for the remainder of the loan term.

Scenario Principal-and interest loan Interest-only for 5 years Interest-only for 10 years Interest-only for 15 years
Monthly repayments during interest-only period $1,889 $1,468 $1,468 $1,468
Monthly repayments after interest-only period $1,889 $2,056 $2,320 $2,778
Total repayments made $679,995 $704,920 $732,963 $764,300
Additional interest paid due to the interest-only period $0 $24,924 $52,968 $84,305

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