Need an interest only home loan?

How interest only loans work

There are 2 parts to any home loan repayment: the principal and the interest.

• The principal is the money you borrow from the lender. It's also called the loan amount. This is the money you have to repay.
• The interest is charged by the lender, as a percentage of the money you've borrowed (the principal). This is how your lender makes a profit. The amount of interest charged depends on the loan's interest rate.

Most Australian borrowers choose principal and interest home loans. They borrow money and pay it back, plus interest at the same time.

With an interest only loan you borrow money but you don't pay it back at first. Instead the lender charges interest, which you pay monthly.

But the interest only period doesn't last forever. It usually only applies for 1 to 5 years. And when the loan reverts to principal and interest repayments, you have to repay both the principal and the interest together.

Here's a quick example using 2 home loans that are identical except for the repayments.

Interest only loan repayments end up more expensive over time

In the scenarios above, opting for interest only repayments for 2 years will cost you $10,051 extra in interest.

In these examples, we can see that 2 years of interest only repayments, while much cheaper initially, end up costing you $10,000 more in the long run.

But this is just a simple hypothetical. In reality, interest only loans have higher interest rates, so you'd pay slightly more. And it's also impossible to accurately calculate loan costs over 30 years because interest rates change over time.

What are the benefits of interest only loans?

There are 2 major reasons borrowers choose interest only home loans even though they cost more in the long run.

Cheaper repayments right now

While principal and interest repayments save you money in the long term, some borrowers need a break right now. In this case, interest only repayments give you some breathing space because repayments are much cheaper. This is helpful if you've lost income or are struggling to make repayments.

It's a short-term strategy, but if you've lost your job or are dealing with unexpected expenses, interest only repayments can be a life-saver.

Tax benefits for investors

If you own an investment property, you're allowed to claim any mortgage interest payments, but not any loan principal payments.

Let's say you have an investment property loan worth $400,000. The interest only repayments are $1,500 per month, while principal and interest repayments are $2,500.

You can only claim the interest part of the payment ($1,500), so you the investor might decide to get an interest only loan to:

• Pay a lower amount each month
• Keep your financial obligations low
• Have a mortgage payment that is fully tax deductible
• Use the money you're not paying on the loan principal towards another non-tax-deductible debt, like your own personal home loan

Some savvy investors buy a property in a booming market and then hold onto it for just a few years. While the property grows in value, they just pay off the loan interest and use it to reduce their tax bill. They also earn rent, which they might put into an offset account or save elsewhere.

But they never repay the loan. Instead, they stick with interest only repayments and then sell the property for a higher price.

Read more about how investors can make use of interest only mortgages.

What are the risks with these loans?

There's nothing wrong with an interest only loan. You just need to be aware of the potential risks and understand exactly what you're getting yourself into.

• Higher interest rates. Interest only mortgages usually come with higher interest rates than principal and interest loans. Of course, the repayments are still lower because you're not paying back the loan amount yet.
• You don't build equity. If your property doesn't grow in value, you won't build any equity in your home if you're not repaying any of the principal. This means from the day you move into the property, you don't own any more of it than the amount you paid for a deposit. You could even end up in negative equity if the property loses value.
• You pay more interest. You have to repay the loan principal eventually. And by not paying off the principal from day one, you get charged more interest.

For the well-informed, well-organised borrower, an interest only loan can work well. But if you don't know what you're doing it can get messy.

How to compare interest only home loans

Every borrower wants the best home loan. Here's what you need to do to find the best interest only home loan for you:

• Compare and get a low rate loan. Every borrower benefits from a more competitive interest rate because it makes your repayments lower. It's not the only factor you need to focus on, but the best interest only loan for you will have a rate that's lower than most.
• Find a loan with the right features. What features you need in an interest only loan depend on your goals and strategy. If you have extra cash lying around (or just some savings) you can use a 100% offset account to save on interest charges. But if you're an investor and you have an owner-occupier loan as well, you may want to save your money there instead (because interest on investment loans is tax-deductible). Some borrowers benefit from extra repayments, allowing them to repay their loan faster.
• Add up the fees. Some loans slug you with monthly fees, which can add up to a few hundred dollars a year. Others come with a hefty one-off application fee while others have no fees at all. So, if you can avoid fees, why not avoid them? Well, if there's a better loan for you with a $200 fee attached, it could still be a more beneficial deal than a worse loan with no fee. Compare the entire loan, not just the fees.

Is it harder to get an interest only home loan?

APRA removed its limits on interest only lending years ago, but lenders are still careful when assessing interest only borrowers.

You can maximise the chances of getting your application approved by:

• Saving a bigger deposit. Many banks are more willing to consider an interest only home loan if you have a lower loan to value ratio (LVR). A bigger deposit, usually at least 20%, will make you a more attractive borrower. Check out our detailed guide to saving a home loan deposit.
• Making a plan. Lenders will want to know why you want an interest only home loan instead of a principal and interest loan. If you can explain your justification for the loan and demonstrate your investment plans, you'll be in a much better position.
• Talk to a mortgage broker. A mortgage broker can help you find a loan that suits your needs and financial situation. The broker vets your application before the lender does, maximising your chances of approval.

Detailed guide to home loan applications

All your interest only questions answered

• What happens when the interest only period ends?

  When your loan's interest only period ends, you start making principal and interest repayments. This means the amount you have to repay your lender increases sharply.

  When the interest only period on your loan ends you should take the following steps:

  • Review your loan's interest rate and repayments. Don't get caught out when your interest only period ends. Make sure you know exactly how much you are paying now.
  • If you want to extend the interest only period, talk to your lender. While this will cost you more in interest over time, you might be able to stay on interest only repayments for a while longer.
  • Compare rates and consider refinancing your home loan. Look at your loan and see if there are more competitive loans on the market you can switch to.

• Can I extend the interest only period?

  This depends on your lender and your own financial circumstances. But it is often possible to extend the interest only period on your loan. You need to check with your lender.

• Can I refinance an interest only loan?

  It is possible to refinance to a new home loan if you have an interest only loan. Borrowers typically start with an interest only loan and try to refinance to a principal and interest loan. Read our guide on interest only refinancing.

• Why are interest only rates higher?

  Lenders decide interest rates based on multiple factors, including risk. Interest only loans attract higher interest rates because they are higher risk loans. Because the borrower is not paying the loan back at first, the lender charges more interest.

• How long can you have an interest only home loan for?

  Most lenders allow you to make interest only repayments for up to 5 years. Some lenders allow it for up to 10 years, but it really depends on your loan and financial circumstances.

• How can I make sure I manage my interest only loan?

  Borrowers with interest only loans need to pay careful attention to their home loan. To help you stay on top of your mortgage you should:

  • Understand when the interest only period ends. You need to understand how long your interest only period lasts for. It could be 2 years or it could be 4. If you don't know or can't remember, check with your lender. You can prepare for the end of the interest only period by using a loan repayment calculator and checking how much your repayments will increase with principal and interest repayments.
  • Build up a savings buffer. If you know that your home loan repayments are going to rise when the interest only period ends, having some extra cash saved up could help you meet the higher repayments. Having a savings buffer is always a good idea. If your loan has an offset account, putting extra savings there is a good idea.
  • Talk to a mortgage broker. A mortgage broker can answer tricky loan questions and help you structure your interest only loan in the way that works best for you. They can offer you some tips for staying on top of your interest only loan too.