Interest only home loans: Could switching to interest-only repayments ease pressure?

A switch to interest-only home loan repayments could be a possible solution for customers who are temporarily struggling amid the coronavirus crisis. If you’re considering this option, Canstar has examined how it could work compared to a repayment pause and rounded up some of the interest-only home loans on its database with the lowest interest rates.

The financial fallout from COVID-19 has resulted in much discussion of home loan repayment pauses or ‘holidays’ for customers who have experienced a drop in income. In other words, asking your bank to put a temporary freeze on your home loan repayments.

However, given its possible long-term impact, a home loan freeze may not be suitable or necessary in every situation, and switching to an interest-only home loan could be an alternative option worth considering. 

Banking regulator ASIC has paved the way for an increase in interest-only approvals, signalling that in light of the challenges facing households, it will not stand in the way of banks approving applications from customers looking to make interest-only payments. 

At the time of writing, several major Australian banks, including three of the big four – ANZ, the Commonwealth Bank and Westpac – are offering a switch to interest-only repayments as a possible option for home loan customers who have been financially affected by COVID-19. 

What is an interest-only home loan?

An interest-only home loan is a lending arrangement which requires you to pay only the interest charged on the amount borrowed (which is known as the ‘principal’) for a period of time. This means that the repayments on an interest-only home loan would be smaller during that period than principal and interest repayments on a home loan of the same size. 

Interest-only home loans can come with either a fixed or variable interest rate, which in some cases can be higher than the rates charged on equivalent principal and interest loans. The interest-only period typically lasts for a set amount of time, such as one, three, or five years. When the interest-only period comes to an end, the loan usually reverts to principal and interest repayments until it is paid off.

The lowest variable rate interest-only home loans on Canstar’s database

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How is going interest-only different to a ‘home loan holiday’?

The key difference is that with a home loan repayment pause or ‘holiday’ your repayments are zero for a period of time, but with interest-only your repayments are simply reduced temporarily. What they have in common, however, is presenting certain potential benefits to borrowers in the short term and possible risks in the long run which need to be weighed up, according to Canstar Finance Expert Steve Mickenbecker.

“Don’t think you’re getting a holiday from interest when you take a home loan holiday,” he said. “Interest is usually capitalised into the amount that you owe, which means that it keeps going up”. 

“On the other hand, with an interest-only loan, you’re covering your interest payments, so the size of the loan doesn’t increase – but nor does it decrease.”

Mr Mickenbecker warned that an interest-only home loan will generally have the same end result as a home loan holiday – higher repayments at the end of the interest-only period. 

He also noted that while home loan holidays are generally available for up to six months, interest-only periods can be longer.

“You may have that interest-only loan for three or five years, and then find at the end of it that you’ve got the same amount to repay, but in a shorter period of time, so your repayments will go up.”

While interest-only loans can last for periods of up to five years, in light of the coronavirus emergency, regulator APRA has said that interest-only periods should be limited in duration if the lender has fast-tracked changes to a customer’s loan. “Where changes to loan conditions are made that result in an interest-only period being granted without a normal serviceability assessment, APRA expects that a reasonable period for such an arrangement would not exceed 12 months,” it said.

Here’s a hypothetical example showing the potential long-term difference between switching to interest-only repayments and pausing them completely. Canstar Research found that over the same six-month period, switching to an interest-only home loan instead of freezing your home loan repayments could save you $11,051 in interest over the life of your home loan (based on a home loan of $350,000 at 80% LVR at the average owner-occupier variable rate from our database of 3.51%). Furthermore, based on the same example, choosing to freeze your repayments for six months instead of switching to an interest-only home loan for the same period would either: 

• Increase your ongoing home loan repayment by $44 a month (from $1,574 to $1,618), vs $16 a month if you went interest-only (from $1,574 to $1,590) 

or

• Increase the time it would take you to pay off your home loan by one year and five months if you kept your home loan repayments the same after the repayment freeze, or by six months if you went interest-only and then chose to keep your home loan repayments the same 

So if you’re experiencing financial hardship but still have the capacity to make interest-only repayments on your home loan, doing so instead of freezing your home loan repayments could potentially save you a significant amount in the long term. 

Could an interest-only home loan be an option worth considering for you?

Moving to an interest-only loan could be a helpful short-term solution depending on your situation – for example, if your working hours have been reduced but you can still afford to make part of the repayments. Depending on your bank’s policies regarding support for customers, you may be able to move to interest-only repayments initially and discuss other options such as a repayment freeze if your income drops further.

If you are ahead on your repayments, you could also consider using those additional funds to meet ongoing repayments, such as by redrawing money or using savings held in your offset account, if your loan comes with one.

If you have weighed up your options and decided that moving to interest-only repayments is suitable for your situation, Mr Mickenbecker suggested that before switching, you may want to “consider the risk that you will end up, at the end of the interest-only period, needing to make much larger home loan repayments.”

He did note, however, that “if at that point servicing your loan becomes too onerous, you can always talk to your bank and ask for an extended loan term.”

Some of the potential pros and cons of an interest-only home loan

Potential pros 

• Possible relief from financial stress due to smaller repayments in the short term
• Potential choice of interest-only period duration to suit your situation
• No interest capitalisation (additional interest being added to your loan’s principal)

Potential cons

• Higher repayments at the end of the interest-only period 
• No increase to your equity (the proportion of your home that you own outright), which could become an issue if property values fall due to the economic impact of the coronavirus, as some have predicted
• Potentially higher interest rate than on a principal and interest home loan

How do you switch to an interest-only home loan?

If you want to switch from principal and interest repayments to interest-only payments, a good first step could be to contact your bank to discuss your situation and ask if this is possible under your current home loan. Your lender can then advise you whether your current home loan allows this, or if you would need to refinance to a new home loan which allows for an interest-only period. 

If your current home loan allows you to change to interest-only payments, you may be able to make the switch via your mobile banking app or internet banking (depending on your bank). If you need to refinance in order to switch to interest-only payments, your bank will generally be able to help you with this either over the phone or online. Bear in mind that if you need to switch to a new loan, you may have to prepare yourself for a detailed application process, as many banks are scrutinising lending requests with even more caution than usual in the current environment.

Switching to an interest-only home loan, like any major financial decision, should be done only after careful consideration, and you may want to speak to a financial adviser before deciding to change your home loan. 

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