The benefits and pitfalls of interest-only home loans
Interest-only home loans can be used by home owners for number of reasons. So what is an interest-only home loan? What are the possible benefits and pitfalls that may affect your finances?
Simply put, an interest only home loan is when borrowers only have to pay the interest as well as any fees for a fixed period of time, usually five to 10 years. During this period, the repayments are a lot lower compared to a principal and interest home loan. Once the interest-only period ends, the home loan will revert back to a principal and interest home loan over the remaining term. For example, if it was a 30 year loan initially and 10 years interest only has passed, the new principal and interest repayments will be calculated over 20 years which could be quite a large increase in repayments. This can often catch borrowers off guard if they forget that the interest only period is expiring.
It is common for investors to take out interest only loans on investment properties. This allows them to make minimum repayments on tax deductible debt, allowing them to direct more of their income to pay off the loan on their owner occupied property which is not tax deductible.
Interest-only home loans may also be a suitable option for first home buyers looking to get their foot in the property market sooner. An interest-only period can help ease first home buyers into repayments and then they will have time to get financially ready for the larger repayments when the interest-only period ends. Home owners could also go through periods where their household income is reduced, for example if one partner reverts to part time work when starting a family. Changing the home loan to interest only during this time could ease the financial pressures.
But just like most financial commitments, interest only home loans have both pros and cons attached. Listed below are just a few.
- Smaller repayments: For the first five to 10 years, your monthly repayments will be significantly lower. This can be useful if you are currently under a tight budget, but know you will be in a better financial position down the track. It can also be a suitable option if you are planning to spend money on renovating the property.
- Tax deductible: As the loan on the investment property is tax deductible debt, investors are often advised just to pay the interest and thereby receive an interest tax deduction for exactly what they pay. By not having to pay principal initially, it also allows them to put extra money towards their non tax deductible debts and funding other assets.
- Get your foot in the door sooner: As mentioned above, interest-only home loans may give buyers an opportunity to purchase a property without being initially overwhelmed with the full principal and interest repayments. An interest only loan could be an option for those who want to ease their way into the property market without spending too much initially.
- Without planning you may run into financial strife: You may find that you can handle the interest-only repayments easily, but what happens when you start making principal and interest repayments? Will you be able to afford it as well as all of your other financial commitments? You may also find that the interest rates will fluctuate quite a bit over the next five to 10 years and it could end up being significantly higher by the time your interest only period ends.
- May pay more in interest: The longer you have your home loan for and the longer it takes to repay the principal owing, the more interest you will pay. If you are only making the minimum principal and interest payments after the interest only period ends, you could end up paying thousands of extra dollars in interest.
- You don't build equity: By only paying interest for the first five to 10 years, you will not have any equity built up in your home. So, if you want to sell before the interest only period ends, you will still owe the full value of the mortgage. Also, if you decide to buy another property, you will not have the advantage of using equity saved in your current home to go towards that purchase.
So what can you do to avoid some of the pitfalls?
If you have an interest only loan, many lenders will allow you to pay extra into the loan or have an offset account linked to the loan. Paying extra into the loan or into the offset account will get you used to higher repayments before it reverts to principal and interest. It can also help you build equity. Anything you pay above the minimum interest only amount will be available for you to redraw.
If you are an investor and want the loan to remain an interest only loan for longer, you can approach your current lender to extend the interest only period or refinance to another lender to start the interest only period again.