Many borrowers shy away from using interest-only (IO) home loans, as they worry that they’ll never make headway with their mortgage. But the beauty of this loan product is that you can use it to your advantage, and make progress on paying down your mortgage principal – provided you know what you’re doing.
An interest-only loan requires the borrower to repay only the interest component of the loan, without having to pay anything towards the principal. IO loan repayments are always lower than principal and interest (P & I) loan repayments, because you are only obliged to repay the interest component.
For instance, let’s say you have an IO loan of $809,201 over 30 years. You would be required to pay the interest charged each month, which on a current home loan of around 4.5%, equates to $1,852 per month.
On a standard P & I loan over 30 years, our mortgage calculator estimates the monthly repayments to be around $4,100.10 per month.
That’s a difference of around $2,248 each month, which could be extra money in your pocket to help you meet other financial obligations.
These types of loans are a great option for those who need some financial flexibility. For instance you may decide to have children, and as a result you drop from a two-income family to one income.
If you switch to an interest-only loan, you can use that extra cash to pay for other living expenses. Alternatively, you might need the cash to meet a short-term financial responsibility such as an unexpected bill, or to boost your savings so you have a buffer to help deal with future emergencies.
When you’re ready you can transfer back to a standard P & I mortgage product, but in the meantime you’re under less pressure when making your mortgage repayments each month.
Keep in mind that just because you opt for an interest-only loan, that doesn’t meant you can’t make payments off the principal.
You are free to make extra repayments as often as you like, but your minimum obligation is lower. In the above example, the minimum monthly repayment is $1,852, but any payment above $1,852 would be paid off the principal. If you find some spare cash and pay $1,922 this month, then the extra $70 will be paid off the principal.
That’s the primary benefit of an IO loan: your minimum obligation is lower, but you have the flexibility to pay as much or as little off the principal amount as you wish.
The idea behind this method is to use the extra money to make headway with other financial obligations, so you don’t fall behind on your regular mortgage payments.
Therefore, those borrowers who are not very disciplined with spending and saving may find that an IO loan creates more problems than solutions, as it frees up extra cash, but also halts your mortgage principal at a standstill for several years.
Interest only loans are usually only available for terms of one to five years, as banks and lenders want to see you make progress with your outstanding principal amount eventually.
At the end of the interest only period your loan will generally revert to a standard P & I loan, with repayments calculated over a 25-30 year timeframe, although it may be possible to apply for another interest only period.
This strategy may not suit everyone so when making decisions to do with your mortgage and finances, make sure you consult an experienced mortgage broker or financial specialist to discuss your needs.
This article was originally written in November 2010 and was updated for content and formatting in July 2018