Is an interest-only mortgage a good idea?

When you apply for a home loan, you generally have the option of making:

• Principal and interest (P&I) repayments, or

• Interest-only (IO) repayments

Principal and interest vs interest only: What's the difference?

If you choose to make P&I repayments, you'll simultaneously pay interest and chip away at the amount you borrowed (the principal) as well. This means the amount of interest you pay will be calculated on a falling principal balance that will eventually shrink to nothing once you pay off your loan.

Definition:

• Principal or principal balance refers to the funds borrowed to buy a property.

• Interest is what a bank or lender charges a borrower accessing those funds. Lenders will typically charge a borrower a portion - expressed as a percentage - of their loan's principal balance in interest each year.

On the other hand, an interest-only home loan will see you paying just interest on the amount you borrowed, while the principal balance remains the same. Interest-only repayments are generally only available for a set period of time.

Invariably, interest only repayments will be lower than principal and interest repayments on the same home loan, as they won't incorporate any of the principal component.

See also: Principal & Interest vs Interest Only Repayments

Pros of interest-only home loans

1. Lower mortgage repayments

We've already touched on the first benefit of an interest-only home loan. Interest-only repayments are lower than principal and interest repayments would be on the same borrowed amount.

Let's crunch some numbers:

If you take out a $600,000 loan with a 6% interest rate for a loan term of 30 years, you could pay $3,597 per month if you were to make principal and interest repayments.

If you were to make interest only repayments, you will be up for just $3,000 a month.

Estimate how your repayments could shrink by switching to interest only: Mortgage Repayment Calculator

However, it's worth noting that making interest-only repayments will only reduce your repayments for the duration of your interest-only period. Your lender will still expect you to pay back your home loan by making principal and interest payments eventually.

Generally, lenders will allow owner-occupiers to make interest-only repayments for up to five years while investors might be able continue making interest only repayments for up to 10 years. When that period expires, principal and interest repayments will apply (unless a borrower refinances to a new interest-only mortgage).

2. Interest-only home loans can help investors improve cash flow while achieving tax advantages

Some investors may aim to save cash while also reaping certain tax benefits when making interest-only repayments on investment home loans. Interest on mortgages funding rental properties are tax deductible, but the portion of any repayment that reduces the principal of the investment loan are not.

See also: What tax deductions can you claim on your rental property?

As there are no tax benefits in paying off a home loan's principal balance, some investors might choose to maximise their cash flow by making interest-only repayments. This strategy can also help them pay for other expenses such as maintenance or even the purchase of another investment property.

Investors who're looking to make a capital gain can employ this interest-only strategy to secure a property and then sell it (ideally for a profit) before their interest-only period expires in a bid to maximise their returns.

You would need to do your calculations before going down this path, however. Professional advice from a tax specialist or accountant is strongly advised.

3. Interest-only mortgages can help borrowers get on top of other expenses

For some borrowers, making interest only repayments for a period can give them space to find their financial feet or get on top of other debts.

As home loan interest rates tend to be lower than interest rates on other debts, deferring the principal portion of their mortgage repayments can allow them to pay down higher-interest debts and put them in a better financial position over the long term.

Interest-only repayments can also give borrowers breathing space should something unexpected come up, like job loss or a major unplanned expense.

In such cases, switching to interest-only repayments can be an alternative to deferring home loan repayments, which many lenders will only allow under certain circumstances.

See also: Home loan arrears and defaults: What you need to know

Reaching out to your lender is the best place to start if you want to investigate switching to interest-only repayments.

Cons of interest-only mortgages

1. You will likely pay a higher interest rate

Interest-only home loan rates are typically higher than for principal and interest repayments on the same loan product. That's because interest-only loans are regarded as higher risk.

Under Australia's credit laws, banks are required to hold more capital against interest-only loans than those with principal and interest repayment schedules. In effect, this makes interest-only loans more expensive for lenders to issue.

They also come with in-built 'payment shock' when interest-only repayments eventually revert to a principal and interest repayment schedule. This could see regular repayments jump significantly, creating a greater risk that borrowers may not be able to cope with the new repayments.

Lenders will generally build in some 'insurance' against such risks when they set their interest-only interest rates.

2. Your interest-only period will not last forever

As discussed, interest-only periods have a time limit - after all, lenders are invariably looking to get their money back. When your interest-only term ends, you may be able to apply to your lender for an extension, although there's no guarantee they will agree.

Ultimately, you will need to have a financial plan in place to meet higher repayments or, alternatively, look to refinance your home loan.

3. You will pay more in interest over the term of the loan

When you make interest-only repayments, the principal balance is not being reduced, meaning your regular interest repayment is being calculated on the same fixed amount each time. The delay in reducing your principal can effectively add thousands of dollars in interest to your home loan.

Let's check the numbers:

If you take out a $600,000 home loan with a 6% interest rate over 30 years and make principal and interest repayments, the total cost of your loan will be $1,295,029.

If you take out the same loan with a five-year interest-only period, the total cost will be $1,339,743. That's an additional $44,714 in interest over the course of the loan.

Source: moneysmart.gov.au interest-only mortgage calculator

4. Slower buildup of equity

In simple terms, equity is how much of your home you actually own once the value of your mortgage has been subtracted. For example, if you purchased a home worth $750,000 with a $600,000 home loan, your equity in it would be $150,000.

In a rising property market, you can essentially build equity just by meeting your mortgage repayments. Let's say in five years' time, your home is worth $900,000 and your home loan with principal and interest repayments has reduced to $580,000 over that period, your equity would now be $320,000.

If you were making interest-only repayments, your equity would still be less at $300,000.

But if property values were to fall and the home you purchased was now valued at $700,000, a principal and interest payer would have a $120,000 cushion, dropping to $100,000 for an interest-only borrower.

In a nutshell, lenders like to see borrowers building equity in their homes as it shields both parties from the effects of falling property prices. It essentially means borrowers have a better chance of paying out their mortgage should they choose to sell their home - or if the bank is forced to in the event of a loan default.

Equity builds more slowly for those making interest-only repayments, leaving them more susceptible to property market downturns and increasing the risk they may not be able to pay back the principal when they sell if they've made no inroads into reducing it.

What to consider before making interest-only home loan repayments

It's important to understand that turning to an interest-only home loan will ultimately cost you more in the long run. If you decide to go ahead, you'll also need to plan for the time the mortgage reverts back to principal and interest repayments.

Ideally, the interest-only period you agree to should be long enough for you to get your financial affairs in order, placing you in a good position to meet the higher repayments when the principal portion kicks in again. Here is a selection of some of the more competitive interest-only home loan rates if you decide to go down that path:

Important Information and Comparison Rate Warning

If an increase to your repayments is likely to present a challenge at the end of your interest-only period, you could consider refinancing your home loan to better meet your circumstances at the time.

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