The pros and cons of interest-only home loans
Interest-only home loans can be a great option for first home buyers and property investors. But what's the catch?
Simply put, an interest-only home loan is when borrowers only have to pay the interest of the loan, 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 to a principal-and-interest home loan over the remaining term. For example, if it was a 30-year loan initially with 10 years interestonly, the new principal-and-interest repayments will be calculated over 20 years. This can be quite a large increase in repayments, and 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, as it allows them to make minimum repayments on tax deductible debt. This means they can 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, so long as they get financially ready for the larger repayments when the interest-only period ends.
Homeowners 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.
As with other financial commitments, interest-only home loans have pros and cons attached. Listed below are just a few.
Smaller repayments: For the 5-10 years, your monthly repayments will be significantly lower. This can be useful if you are currently under a tight budget and 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 sufficient 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 5-10 years, and it could end up being significantly higher by the time your interest-only period ends.
You may pay more in interest: The longer you have your home loan (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 5-10 years, you will not build up any equity 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.
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 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 interest-only 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.
The opinions expressed in this article are the opinions of the author(s) and not necessarily those of homeloans.com.au. The above is general commentary only and is not advice tailored to any individual's financial situation. We recommend seeking advice from a finance professional before implementing changes relating to your finances.