Interest only fixed rate mortgages

Interest-only fixed rate home loans can be less expensive loans in the short term, as you only repay the interest portion of the home loan repayment. This means you don't pay any amount towards the principal each month, and you have repayment certainty, because your interest rate doesn't change.

The down side? With an interest only loan, you're not repaying any of the debt. If you take out a $500,000 IO loan and make repayments for two years, then after two years of interest-only repayments, you'll still owe $500,000.

These home loans may not seem to make sense at first (who wants to make repayments on a debt that never goes down?!) But, they actually serve a solid purpose for a really specific type of borrower: usually an investor, or an owner-occupier who needs to lower their repayments for a while. After the table of options, let's dive into how these loans work and how to apply for them.

How do fixed rate interest-only home loans work?

Interest-only home loans are mortgages that require you to pay only the interest on the amount you have borrowed, rather than paying off the principal amount in instalments each time you make a repayment. If you have borrowed $500,000, your monthly repayments will be lower on an interest only repayment than on a regular home loan contract, where you pay off the principal amount as well as the interest.

• $500,000 fixed rate loan with interest only (IO) repayment at 2.19%: $1,895
• $500,000 fixed rate loan with principal and interest (P&I) repayment at 2.19%: $913

The repayments are much lower with an IO loan, as you can see – in our example above, it's less than half. This means you'll pay almost $1,000 less per month, or $12,000 less per year.

But, the flip side to that coin is, at the end of one year, the full amount of $500,000 would still be owing. With the P&I loan, you would have chipped away at $12,000 of the debt by then. Your home loan balance would be repaid down to $488,000, so you're making progress towards owning your home outright.

What are the benefits of a fixed rate interest-only home loan?

A fixed interest rate loan allows you to budget precisely each month, as the amount you are required to pay back never changes.

This can make monthly repayments easier to manage, especially if your interest-only repayments are being made on a property you are not yet living in (such as a home that's under construction).

Fixed rate interest-only home loans are short-term home loan contracts that only usually last for one to five years.

The important thing to know about interest-only home loans is that they are only available for short periods of time, as the bank eventually wants to see you make some headway with the principal. Think about it this way: if you had an interest-only home loan forever, you'd never own your own home. They are not recommended as a method to help you pay for your mortgage and afford your everyday living expenses.

Finder survey: How long is the average Australian's fixed rate home loan?

Who are these loans suited to?

Interest-only home loans are traditionally tailored for and suited to investors who plan to sell after only a short period of time and whose personal financial situation doesn’t necessarily benefit from paying off the principal borrowed amount. However, interest-only home loans are becoming more popular with people who might benefit from a short period of substantially lower repayments, including:

• You are buying a property as an investment and plan to sell after renovations or after a small period of time has lapsed.
• You are planning renovations on the property you are buying and still need to pay your rent or mortgage repayments on another property in the meantime.
• You have just gone freelance or have a fluctuating income and are expecting a short period of irregular income.
• You would benefit from a short time of lower monthly repayments for another reason and building equity for the time being or borrowing against your existing home loan is not suitable for you.

How to compare fixed rate interest-only home loans

• Maximum loan amount. While you are searching for the loan thats suits you, one of the first things you will ask about is the maximum amount that you can borrow for this kind of loan.
• Maximum Loan to Value Ratio (LVR). The LVR is the amount of money you are borrowing compared to the value of your property.
• Offset account. Offset accounts can be a huge help when you’re paying off a home loan, especially one packed with features and flexibility. Proper use of an offset account that suits your needs can mean saving thousands in interest over the life of the loan. These are rare on a fixed rate loan.
• Repayment flexibility and loan options. Finding a lender and a contract that suits your specific needs is very important. Features like the ability to make extra payments without incurring charges, or the flexibility to choose whether to make your installments weekly, monthly or fortnightly, can help to tailor a home loan that suits you.
• Redraw facilities. Being able to redraw from your home loan and take advantage of any extra payments can be helpful if you find yourself in a tight spot.

Make use of home loan comparison tools and calculators to see how the banks and lenders measure up to each other.

Things to consider about a fixed rate interest-only home loan

While it might seem like a great idea at the time, interest-only home loans should be taken out with caution and there are some pretty significant disadvantages to be aware of before you sign up.

The most glaring downside is that you are not actually paying off your home. This means that you are not building equity, and at the end of the loan period you are essentially where you started.

Another problem with fixed rate interest-only home loans can be that once your interest-only period is over, the amount you will need to pay in monthly instalments will actually increase. This is because the principal amount will not have changed and nor will the loan term, meaning that the same amount will have to be paid back in fewer instalments.

If you are using an interest-only home loan to bet on an investment, a lot rests on your ability to pick the market. While we do have a relatively stable property market here in Australia, real estate can be full of surprises. If you get it wrong you are looking at higher monthly repayments, paying more money in interest over the life of the loan or even losing money.

How to apply for a fixed rate interest-only home loan

• Deposit. The rule of thumb for the beginning of any home loan is to have a 20% deposit upfront. This makes not just the down payment more manageable, but also all of the start-up fees and charges associated with a home loan.
• Meet income requirements. In order to be eligible for a home loan, you will need to meet income requirements.
• Guarantor. If you don’t have enough upfront or enough documentation to prove your ability to pay back the loan, using a family home as a guarantee can help you meet eligibility requirements.

If you think you are eligible and would like to apply, you will need to provide documents to prove your case to your bank or lender.

• Identity. You will need to provide appropriate documentation to prove your identity.
• Proof of income. Payslips, tax statements and other proof of a steady income will be required when applying for a home loan.

When you are considering entering the property market for the first time or as an investor, it pays to ask lots of questions and shop around to find the home loan that suits you, your lifestyle and your financial requirements.