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What is an interest-only home loan?

A typical home loan repayment consists of two parts:

• The principal - the amount you borrow
• The interest - the amount a lender will charge you on your outstanding balance

With an interest-only home loan, mortgage holders are only required to pay off the ‘interest’ part of the loan, rather than the principal and interest (P&I) for an agreed period of time, usually between three to five years.

For some borrowers, having an interest-only home loan is a suitable way to ease themselves into the loan by making the bare minimum repayments. What this means is that your home loan balance won’t reduce during the interest-only period since you’re technically not paying off the amount you borrowed. Additionally, interest rates for interest-only home loans tend to be higher than P&I home loans.

If you’re considering an interest-only loan, you’ll want to do some research to find out all the elements involved and ultimately whether it’ll suit your needs and circumstances.

What happens when an interest-only loan expires?

Like anything, an interest-only home loan doesn’t last forever.

When the time comes, your interest-only loan will automatically roll over to P&I repayments. This means you’ll start paying off the amount you borrowed as well as the interest.

There are three options you can follow if your interest-only loan period is ending.

1. Extend the interest-only period: If possible, your lender may be willing to extend your interest-only period to keep you as a customer.

2. Get ready for P&I repayments: If you’re ready to make the switch to P&I repayments, ride out the expiry of the interest-only period and settle into P&I repayments with no hassles.

3. Refinance: Maybe you’ve done some research and seen a better rate on the market. If so, you might want to look at refinancing your home loan with your current lender or a potential new one to take advantage of any beneficial features.

How long can you take out an interest-only loan for?

On average, lenders offer interest-only periods between three to five years. However, if you have a chat with your lender, they may be able to offer you up to 15 years but this is generally reserved for investors.

What are the benefits and disadvantages of an interest-only home loan?
No matter what type of home loan you decide to take out, it’s always a good option to weigh up the pros and cons involved. Below is a list of some of the benefits and risks you could encounter when taking out an interest-only home loan.

The advantages of interest-only home loans

• Lower repayments: The lower initial payments of an interest-only loan can make it easier for borrowers to save more, pay off outstanding debts, or purchase a property sooner. Interest-only loans also benefit buyers who are experiencing financial hardship or a temporary reduction of income. This is possibly the biggest appeal for interest-only loans.

• Tax incentives for investors: If you’re an investor, you could claim higher tax deductions from an investment property. According to the ATO, investors can “claim a deduction for the interest charged on the loan or a portion of the interest.”

The disadvantages of interest-only home loans

• The repayments will eventually go up: An interest-only loan can only last for so long so you need to be confident that you can manage P&I repayments when the loan expires.
• Higher interest costs: You end up paying more in interest over the life of your loan than you would with a P&I loan. To explain this further, with a P&I loan, as the principal amount decreases, so too does the amount of interest being charged.
• Generally higher interest rates: When you’re conducting research on an interest-only home loan, you may notice that they generally have a higher rate of interest compared to a P&I loan.
• Less equity buildup: With an interest-only loan, you may not be building any equity in your property. If the value of your property was to possibly fall, you could end up owing more to the lender than what the property could sell for if you had to sell for any reason

Interest-only vs principal and interest

To show you the difference between the two payment types, we’re going to compare how much interest a mortgage borrower would pay for an interest-only loan versus a principal and interest loan.

For example, John Smith decides to take out a home loan of $500,000 for 30 years.

For the purpose of this comparison, it’s assumed John’s interest rate is 3.00% p.a which holds steady over the 30 years for both the interest-only loan and the P&I loan.

For the interest-only loan, John opts to pay this for five years before switching to P&I for the remaining 25 years.