Interest-Only Home Loans

Interest-only home loans are a type of home loan product offered by lenders. One in four owner-occupier home loans in Australia is interest-only, while two out of every three property investors choose this option over the more traditional principal and interest (P and I) repayment method.

What is an interest-only home loan?

Interest-only home loans require the borrower to make interest and fee repayments for a defined period (usually up to five years). There is no reduction of the principal (i.e. the amount borrowed) during this time.

At the end of the interest-only period, the loan typically reverts to a standard P and I type of home loan product. Under this arrangement, a portion of the principal reduces with each repayment made by the borrower until the outstanding balance is repaid in full.

What are the pros and cons of interest-only home loans?

Interest-only home loans have both advantages and disadvantages, just like all types of home loan products do. Whether they are a good option depends on:

The borrower’s personal financial circumstances.
Interest rate movements. For example, if rates increase significantly, the borrower will be charged more because they still owe the same amount, rather than having reduced their loan balance with each repayment (as they would with the P and repayment method).

The advantages:

Repayments on these types of home loans are lower than they are for P and I loans of the same initial amount. This is because borrowers are not repaying any principal during the interest-only period.
These loan products provide higher tax deductions on investment properties. This is because the principal doesn’t reduce. The amount of interest charged by the lender is therefore more than it would be for a comparable P and I home loan product.
These home loans can be used by borrowers for short-term purposes, such as bridging or construction loans. Bridging finance helps borrowers to fund the purchase of a new property while they are waiting for funds from the sale of their existing property. A construction loan finances the building of a new dwelling. Once construction is completed, the interest-only loan can convert to a standard P and I home loan product.

The disadvantages:

Overall repayments on an interest-only loan that ultimately converts to a P and I arrangement are higher for borrowers. This is because the principal isn’t reduced during the interest-only period and charges are higher accordingly.
Borrower repayments increase significantly once principal repayments are added at the end of the interest-only period. This is often because the P and I repayment time period is shorter than it otherwise would have been. For example, a five-year interest-only period on a standard 30-year home home loan reduces the P and I repayment term to twenty-five years. Borrowers therefore need to ensure that they will be able to make these higher repayments when the loan converts to P and I, otherwise they may be forced to sell their property.
Borrowers do not build any equity (ownership) in their properties during the interest-only period via their repayments, like they would with P and I home loan products. They will only build equity if the value of the property increases. There is no guarantee that this capital growth will occur, and the property could even lose value if there is a market downturn.
Rates on these types of home loan products may be higher than for P and I loans. Gaining approval from lenders may also be more difficult for borrowers. This is because the Australia’s financial industry regulator (the Australian Prudential Regulation Authority) limits the amount of interest-only loans that lenders can provide to a maximum of 30% of all their approved home loans. This restriction is intended to limit the amount of speculative investment in the property market.

Who do interest-only home loans suit?

Interest-only home loans generally suit three types of borrowers:

Those needing short-term financing arrangements, such as bridging or construction loans.
Borrowers who will gain benefits that will outweigh the long-term costs. For example, property investors seeking to maximise their tax deductions while also generating capital growth to offset the higher long-term repayments.
Borrowers who can budget effectively to meet their higher future repayments.

How to choose the right interest-only home loan

When comparing interest-only home loans offered by different lenders in the market, it is important for borrowers to be aware of the comparison rate. Two rates are typically advertised on a loan product: nominal and comparison. The comparison rate is the higher of the two and provides the total cost of the loan. It includes both interest and all associated fees/charges. Borrowers that choose the lowest comparison rate will therefore be charged less for their home loan product. Under the National Credit Code in Australia , lenders are legally required to provide borrowers with the comparison rate on their products. This allows borrowers to accurately compare the actual total costs of different loan products.

Borrowers can also reduce the amount of interest that they pay on any home loan product (including interest-free loans) via lenders who offer an offset account feature. This account allows a borrower to offset the balance of the deposit funds that they have in a separate offset account with the lender against their outstanding home loan balance. For example, if a borrower takes out an interest-only loan of $500,000 and has $20,000 in an offset account, they would be charged interest on $480,000 (instead of $500,000).

The bottom line

Taking out any type of home loan is a major financial decision and an interest-only home loan is no exception. The market is highly competitive, and it is worthwhile for borrowers to seek professional advice to compare home loan rates, terms and conditions. This allows the most appropriate option for the borrower’s individual financial circumstances to be identified.

If you’re interested in a interest-only home loan book an appointment to speak with one of our home loan specialists. Or start to compare home loans online.