When you’re ready to take the plunge into homeownership and start the steps toward securing a home loan by talking to a bank or lender, you might be given two different loan repayment options. Chances are good that the idea of an interest-only home loan made your ears prick up. Exactly how an interest-only home loan differs from its counterpart of an interest and principal loan is pretty straightforward.
Every loan repayment is structured to factor in two components, regardless of whether you’re making repayments on a weekly, fortnightly, or monthly basis. You will be paying the following:
- The principal loan amount — the amount of money you borrowed from the bank or lender
- The interest — the interest accrued on the outstanding amount of money you borrowed
Unlike a standard home loan, an interest-only home loan allows you, the lender, to pay only the interest and not the principal amount owed on a home loan.
An interest-only home loan is usually secured for a fixed period of time and this arrangement applies to a maximum interest-only period of 5 years for an owner/occupier and 10 years for an investment property.
After this interest-only period, the loan then reverts to a traditional mortgage and you’ll start paying both principal and interest whether you’re ready or not! Though as a side note, at this juncture, you may have the potential to refinance your loan completely, resetting the terms and potentially looking for a second interest-only home loan.
No principal, no-brainer, right? Well, time to pay a visit to our old friend Nuance.
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Interest-Only Home Loans — Weighing Up Your Options
Now that you now the difference between these two loan structures, let’s put the particulars of each on the scales and see which way they tip:
Advantages of interest-only loans
- Lower mortgage repayments for a limited time to suit your lifestyle (e.g. taking time off work to start a family)
- Possible tax benefits for investment loans
Disadvantages of interest-only loans
- Principal amount will not reduce during interest-only period
- Higher repayments once the interest-only period finishes
- Higher interest rate during interest-only period
- More interest payable over the life of the loan
Advantages of a principal and interest loans
- Pay less total interest over the life of the loan
- Pay a lower interest rate for an equivalent home loan when compared to interest-only rates
- Pay off your loan faster, meaning you’ll own your property outright sooner
Disadvantages of a principal and interest loans
- Repayments are higher than interest-only
- May not be as tax-efficient for investment loans
You don’t need a degree in astrophysics to see that the risks and costs of an interest-only home loan unfortunately end up making it the less appealing option when the two laid out side-by-side.
While interest-only repayments do marvelously lower your repayments during the interest-only period, you’ll end up paying way more interest over the life of the loan — and that really is the bottom line.
So knowing that, why would anyone still be toying with the idea of an interest-only home loan?
Tipping The Scales — Why An Interest-Only Home Loan Can Still Be Appealing
An interest-only home loan can still be ideal in certain situations for some buyers. While that may sound like lots of hypotheticals, when determining if you can afford to buy, you are likely to be asking yourself two main questions:
- Can I afford the initial layout?
- Can I afford the mortgage repayments?
If the answer to the first question is yes and the second question is no, then the best option might just be an interest-only home loan.
Here are some concrete examples showing how an interest-only home loan could punch above its weight class:
A young professional with a rising income
Scenario: A medical student in their final years of university decides to buy a home. They know that once they finish their residency, their salary will increase significantly over a few years.
Benefit: The lower monthly payments during the interest-only period allow them to afford a home now, even on a lower income. Once their income increases, they can afford the higher payments when the interest-only period ends, or they can pay down the principal faster.
A real estate investor with a short-term plan
Scenario: An experienced real estate investor buys a property that they expect to appreciate quickly over the next 5 years. They plan to sell the property before the interest-only period ends.
Benefit: The investor can minimise their carrying costs (monthly mortgage payments) with the interest-only loan, thereby maximising their cashflow. By selling the property before the higher payments kick in, they avoid ever having to pay the principal and may capture the appreciation in the property’s value, especially if they’re saving on the repayments and funneling the extra cash into improvements.
A homebuyer expecting a future large lump sum
Scenario: If a buyer knows they’re due to receive a significant inheritance or trust, they might want to buy a home now, but are currently having to prioritise their cashflow for other investments or expenses.
Benefit: The interest-only loan allows them to keep monthly payments low until they receive the lump sum. Once they get the money, they can pay off or pay down the principal on the loan without being burdened by high payments in the meantime.
In all these cases, the key is that the borrower expects a significant future increase in income, property value, or capital, making the transition to higher payments more manageable — and this type of loan very appealing.
More frequently though, an interest-only home loan might be the solution if you’re searching for a way to lower your mortgage repayments when you’re really feeling the pinch.
Lower monthly repayments for a period of time can be incredibly helpful if you’re struggling financially as it gives you greater control over your cashflow and any new or existing investment, for those lucky enough to have them in the first place.
The attractiveness of interest-only loans also fluctuates with interest rates. In periods of higher rates, the appeal may diminish as the interest-only payments are still high, but can still be a valid option if you’re in need of some financial breathing room.
Is It More Difficult To Secure An Interest-Only Home Loan?
In short, yes, interest-only loans are often more difficult to qualify for as lenders typically require a higher credit score, a larger deposit, and proof of strong financial stability.
In the case of the scenarios outlined earlier, you would need to have confirmation of any one of these to present to your lender and support your desire for an interest-only home loan at the time of your application.
An Interest-Only Home Loan As A Feasible Option
If you’re still interested in taking this route into the property market as either an owner/occupier or an investor, hopefully now you have a more rounded idea of what you’re in for with an interest-only loan.
Over the life of your loan, you will ultimately be paying more money in interest. But if you’re able to plan wisely for the inevitable moment when the interest-only period runs out and have used the period of lower monthly repayments to set yourself up, you should be sitting pretty.
We’re not always where we want to be financially when opportunity comes knocking, but that doesn’t mean we need to slam the door shut in its face. An interest-only loan could be just the foot in the door you need.