The low repayments of an interest-only mortgage may be attractive on the surface, but is it the right choice for you financially? Before you get an interest-only home loan, you should understand what it is, how it may be beneficial and what you need to consider before signing the contracts.
What is an interest-only home loan?
An interest-only home loan is a mortgage where all you repay is the interest charged on your loan amount. This means you're not repaying any of the loan amount or money you've borrowed from the lender, just the interest charged on that amount. Lenders will restrict how long you can make interest-only home loan repayments. Yard, for instance, only allows borrowers to opt for interest-only repayments for up to five years.
Why might you consider an interest-only loan?
- Tax deductions for investors - If the property is an investment, you could claim the interest on the loan drawn to buy the property as a tax deduction, by using it to offset against rental income. If you’re not repaying the principal, your interest expense won’t decrease, assuming interest rates remain the same, hence maintaining the same level of tax offset. Your accountant can help advise if this is the right strategy for you.
- Short-term savings or cash flow increase - You may want to bump up your savings for a period after purchasing your property to buy a new car or plan a holiday for your family. Or your circumstances may have changed, and you need some extra cash to cover expenses.
- Grow other investments - Lowering your repayments by choosing interest-only for a period could allow you to diversify your investments. You could use the extra cash to purchase shares or other investment products outside real estate.
What do you need to be careful of when looking at an interest-only mortgage?
- Higher interest rates - Interest-only home loan rates are usually higher because lenders see them as a higher risk.
- Paying more interest - You'll end up paying more interest over the life of your loan. During the interest-only period, you're only paying the interest and not paying down your debt, reducing the interest charged. This means the total interest you pay over the life of your loan will end up being more.
- Short term only - Lenders only allow you to choose an interest-only mortgage for a specific period. After this period, your repayments will revert to principal and interest, which means they now include the principal and will be higher than during the interest-only period. You’ll need to prepare for this increase and budget accordingly.
- Not building equity - Because you're not paying down any principal, you're not building up any equity in your property.
Are interest-only home loan rates different from other interest rates?
You'll find most lenders will have higher interest rates on interest-only home loans than they do on principal and interest mortgages. This is because, for lenders, an interest-only home loan is riskier than one that pays down the principal, which means interest-only home loan rates are higher.
Tips to help you avoid the shock of an interest-only home loan reverting to principal and interest
- Budget for the change - When you’re approaching the end of your interest-only period, it will help if you adjust your budget to include an increase in your home loan repayments. For example, you could start by putting $50 away a week and gradually increasing this amount each week. Continue this until that amount, when combined with your current repayments, is equal to or close to the amount you’ll be repaying each month with principal and interest. You can work out the new repayment amount using the revert rate and a mortgage repayment calculator.
- Shop around for a new home loan - Find out the principal and interest rate your loan will revert to, and then see what other principal and interest rates are available in the market. You may find a rate that will make your new principal and interest repayments less of a shock when your interest-only mortgage period ends. Refinancing to a new loan rather than letting your repayments just revert could save you money and help you manage your finances.
- Talk to your lender - Talk with your lender about what home loan deals they have when your interest-only period is due to end. They’ll likely be keen on keeping you as a customer and will help you refinance, making it easier for you and them.
Opting for an interest-only home loan can help free up cash flow and is a great tax deduction if you’re an investor, but it’s a short term solution. You need to make sure it's the right financial decision for you before jumping in. It may be advisable to seek professional financial advice before opting for an interest-only mortgage.