Interest-only loans

Interest-only home loans have been making a comeback in the lending landscape. But are they a clever financial strategy or a potential trap? As mortgage brokers who've guided hundreds of families through property purchases, we're breaking down everything you need to know about interest-only loans – no sugar-coating, just facts.

What exactly is an interest-only home loan?

Let's get straight to the point: with an interest-only home loan, your repayments only cover the interest on your borrowed amount (the principal) for a set period – typically between 1-5 years.

Here's what that means in practice:

• You're only paying the interest charges
• You're not reducing your actual loan balance during this period
• When the interest-only period ends, your repayments will increase significantly as you begin paying both principal and interest
• The total loan term remains the same, but you'll be paying off the entire principal in a shorter timeframe

The real numbers: How interest-only loans affect your repayments

Let's break this down with real numbers. Imagine you're borrowing $500,000 over a 30-year loan term:

Scenario 1: Principal and Interest from the start (at 3.99% p.a.)

• Monthly repayment: $2,385
• Consistent repayments throughout the loan

Scenario 2: Interest-Only for 5 years, then Principal and Interest

• Monthly repayment during interest-only period (at 4.61% p.a.): $1,921
• Monthly repayment after interest-only period ends (at 3.99% p.a.): $2,637
• That's a jump of $716 per month when the interest-only period ends!

The immediate savings during the interest-only period come at a cost – higher repayments later and more interest paid over the life of your loan.

Interest-only home loans at a glance: Pros and cons

Who should consider an interest-only loan?

Interest-only loans aren't for everyone, but they can make sense for:

Property investors

• Maximises tax deductions as investment loan interest is generally tax-deductible
• Potential for improved cash flow management
• Could allow for investment in other growth assets

Short-term financial strategies

• Bridging finance when buying a new property before selling an existing one
• During construction loans when you're paying rent and building simultaneously
• When managing temporary income reductions (parental leave, study, etc.)

First-time homebuyers with expected income growth

• If you're confident your income will increase substantially before the interest-only period ends
• When you need lower initial repayments to enter the market

The serious downsides you need to consider

Before jumping into an interest-only loan, understand these significant disadvantages:

Higher interest rates

Most lenders charge higher interest rates for interest-only loans compared to principal and interest loans. This means you'll pay more interest over the life of your loan.

No equity building (unless property values increase)

During the interest-only period, you're not building equity through principal reduction. Your only equity growth comes from property value increases – which aren't guaranteed.

Repayment shock

When the interest-only period ends, your repayments will increase significantly. Many borrowers underestimate how much higher these payments will be.

Limited availability

Interest-only periods are typically capped (often at 5 years for owner-occupiers and 15 years for investors), and they're not available in the final years of your loan term.

How to handle the switch to principal and interest repayments

The transition from interest-only to principal and interest is where many borrowers struggle. Here's how to prepare:

Gradually increase your repayments before the switch

If your loan allows additional repayments, start incrementally increasing your payment amount before the interest-only period ends. For example, if your repayments will increase by $700 monthly in a year, start adding $100-$200 extra each month now.

Negotiate a better interest rate

Before your interest-only period ends, shop around for better rates. Use comparison sites to find competitive offers and ask your current lender to match them or provide a better alternative.

Consider refinancing

If your lender won't offer a better rate, refinancing could be an option. Just ensure the benefits outweigh the costs of switching loans.

Create a buffer

Use the lower repayment period to build an emergency fund that can help absorb the higher repayments if needed.

Interest-only loans: Make an informed decision

Here's our straight-talking advice:

1. Do the math properly: Don't just look at the immediate savings – calculate the long-term costs and higher future repayments.
   
2. Be realistic about your future financial situation: Can you genuinely afford the higher repayments when the interest-only period ends?
   
3. Have an exit strategy: Whether it's transitioning to principal and interest, refinancing, or selling the property, know your plan before you start.
   
4. Don't use interest-only as a band-aid: If you can only afford a property with an interest-only loan, you might be looking at properties beyond your means.
   

The bottom line

Interest-only loans can be a legitimate financial strategy for specific situations, particularly for property investors and those with a solid plan for managing the eventual increase in repayments.

However, they're not a magic solution for affordability issues, and they come with significant long-term costs and risks.

Want to know if an interest-only loan makes sense for your specific situation? Book a free consultation with our team. We'll run the real numbers for your circumstances and help you make a decision that works for your long-term financial goals, not just your immediate budget.

Remember: The right loan structure should align with both your current financial situation and your future goals. Sometimes the slightly harder path now leads to much greater financial freedom later.