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Pros and Cons Of Interest-Only Home Loans

Co-author: Ellie McLachlan

If you’re considering an interest-only loan, here are some pros and cons you need to know about.

Some people might view an interest-only home loan as an attractive choice when considering finance options for a home. However, interest-only loans were designed with very specific types of borrowers in mind, and that may not be you. If you are considering an interest-only home loan, it’s vitally important to weigh up some pros and cons of this type of loan.

What is an interest-only home loan?

An interest-only home loan is a type of home loan where you only have to make payments of the interest on the loan for a set period of time. You don’t have to repay the principal on the loan (the loan amount) like in a principal and interest (P&I) loan.

The table below displays a snapshot of variable rate home loan products available for investors on Canstar’s database, with links to providers’ websites. The table is sorted by the current advertised interest rate (lowest-highest), then by provider name (alphabetically).

The products displayed are based on a loan amount of $350,000 in NSW at 80% LVR or higher and available for interest-only repayments. Read the Comparison Rate Warning.

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Interest-only loans typically have a maximum period of 5 years, after which the loan reverts to the normal principal and interest repayments.

Interest-only home loans are not designed for every type of borrower. Interest-only home loans may not be a good idea for standard home buyers looking to pay less on their monthly repayments because the less you repay of the loan amount (the principal), the more you end up paying in interest on your loan over the years.

Instead, interest-only loans can be useful for property investors who can claim the interest as a tax deduction, first home buyers trying to make their first year of loan payments more affordable after the initial upfront expenses of buying, or buyers who only plan on holding onto the property for a few years before selling it.

Importantly, it’s worth noting that in 2017 the Australian Prudential Regulation Authority (APRA) placed restrictions on interest-only home loan lending due to concerns for borrowers amid heightened risks of household debt and rising house prices. This means any bank or lending institution in Australia now has to strongly justify any instances of interest-only lending and lending to investors.

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What is interest only home loan for investment

 

Benefits of an interest-only mortgage

Interest-only mortgages or home loans can have some short-term benefits such as lower monthly payments, potential tax benefits and may free up cash to invest elsewhere. These benefits should, however, be taken with a grain of salt once you consider the disadvantages/cons.

Lower monthly payments

Because you are paying only the interest component on your home loan, your monthly payment will be comparatively lower.

For example, on a $300,000 mortgage over 25 years at a 5% p.a. interest rate, the usual monthly repayment would be approximately $1,754/month. But if you were making interest-only payments, the monthly cost would be approximately $1,250/month. These calculations were made using Canstar’s Mortgage Repayment Calculator.

Canstar's Mortgage Repayment Calculator

May help maximise tax deductions

An interest-only home loan generally presents potential tax benefits to investors. If the interest paid on the home loan is a tax deduction the investor can claim, then paying interest-only maximises that deduction for the investor.

After all, paying off the principal means that interest would be charged on a smaller amount, which reduces the dollar amount of the tax deduction.

An investor might take out an interest-only mortgage on a property and count on the property appreciating (growing in value) to repay the principal at the end of the term.

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Frees up cash to invest elsewhere

In the investor example above, paying interest-only (with the interest being tax deductible) would free up extra cash to put towards something that isn’t tax deductible – such as another investment loan, business running expenses, or the cost of studying.

There are plenty of other goals that can improve our wealth over the long term, so there’s plenty of ways to put that extra cash to better use than repaying principal on an investment loan.

Disadvantages of an interest-only home loan

Interest-only loans have some distinct disadvantages over other types of home loans, especially highlighted by APRA’s enforcement of lending restrictions on Australian banks and lending institutions since last year. Here are just some of the cons of choosing an interest-only home loan:

Not available from every lender

Not every lender offers interest-only loans, even for investors. You’ll have to look a bit harder for an interest-only home loan and your application will be seriously assessed to make sure you are a suitable borrower for this type of loan.

Still needs to be paid off at some point

Unless it’s an investment property or you are intending to sell within a few years, chances are that you will need to pay off the principal of the loan at some point.

Most interest-only loans are only available for a few years, with none of the principal being repaid during that time. So when the loan reverts to a P&I (principal and interest) repayment, the sudden surge in the cost of monthly repayments can be a shock. Unless there is a specific (and good) reason for you to be choosing an interest-only loan, you could just be delaying – at your own cost – the inevitable.

The table we’ve created below shows how much an interest-only loan will cost over time, assuming the interest-only term runs for 3 years, 5 years, or 10 years before reverting to P&I for the remainder of the loan.

With a normal P&I loan for $350,000, the total cost of the loan after 25 years is $596,813 – which includes paying interest of $246,813 in total.

But with an interest-only loan of 10 years, you could end up paying more than $58,000 extra in interest payments on top of the usual.

Cumulative Cost of Loan - Canstar
Source: www.canstar.com.au, 2017.

Property might depreciate

Another risk with interest-only loans is that if your property loses value while you are not repaying any of the principal, then you could end up owing more than it is actually worth, possibly requiring you to sell for a loss.

Interest rates are currently low

Home loan interest rates are comparatively low, certainly when compared with historical rates – so it’s a good time to pay off some of that dreaded home loan principal amount. That way, if rates rise in the future, you will be paying those higher rates on a reduced loan size.

Could tempt you to spend more money than you can really afford

Paying interest only frees up your cash-flow – but if you end up using that extra cash to pay for day-to-day ‘stuff’ rather than for additional investments or to pay down other debt, it could well be wasted money. This could lead you to rely on this extra cash-flow for your living expenses.

Cons of paying just interests only loans

Is an interest-only loan the right option for me?

This type of loan can be useful for property investors who can claim the interest as a tax deduction, first home buyers trying to make their first year in their new home more affordable, or buyers who only plan on holding onto the property for a few years before selling it.

Interest-only home loans may not be a good idea for standard home buyers who are looking to pay less on their monthly repayments because the less you repay of the loan amount (the principal), the more you end up paying in interest over the years.

Compare interest-only loans

Overall, if you’re considering an interest-only home loan, carefully consider the potential pros and cons and get some professional advice. At the end of the day, you want to be certain that whatever your choice, you’re doing the right thing for your finances.

To help you decide what’s best for your budget, we’ve developed a wide range of Online Mortgage Calculators. Check out our Home Loan Repayments Calculator and Home Loans Comparison Calculator when comparing your options.

 

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