Interest-only loans

How interest only loans work

There are two parts to any home loan repayment: the principal and the interest. Principal is the total amount of outstanding debt, and interest is the price you are paying in order to access that funding.

• Principal – is the money you borrow from the lender. It's also called the loan amount and eventually, the goal is to repay the loan principal in full.
• Interest – is charged by the lender, as a percentage of the money you've borrowed (the principal). This is how your lender makes a profit. The amount of interest charged depends on the loan's interest rate.a

With those two concepts explained we can now talk about the two home loan repayment types, principal and interest home loans and interest only home loans.

Principal and interest repayments

Most people know how regular home loans work: you have a monthly repayment comprised off both principal and interest repayments. Each month, you repay a little towards the loan principal and a portion of the loan interest. Pretty straightforward, right?

The lender calculates these repayments so that you pay more interest at the start and over time, the amount of principal you repay increases and the amount of interest decreases, until the debt is repaid. This is called amortisation.

When you have an interest-only loan, you just repay the interest, not the money you've borrowed (the principal). It means that you make no headway whatsoever with your debt – in fact, after 12 months of interest only repayments, you'll still owe exactly the same amount as you did when you took the loan out. Why would anyone want this kind of loan, if you don't make any progress towards paying down the debt?

Why get an interest only home loan?

The biggest reason why people opt for this type of home loan is the tax benefits. If you own an investment property, you're allowed to claim any mortgage interest payments, but not any loan principal payments.

Let's say you have an investment property loan worth $400,000. The interest only repayments are $1500 per month, while principal and interest repayments are $2500.

You can only claim the interest part of the payment ($1500), so you the investor might decide to get an interest only loan to:

• Pay a lower amount each month
• Keep their financial obligations low
• Have a mortgage payment that is fully tax deductible
• Use the money they're not paying on the loan principal towards another non-tax deductible debt, like their own personal home loan.

The interest only period doesn't last forever. In fact, it usually only applies for one to five years. And when the loan reverts to principal and interest repayments, you have to repay both the principal and the interest together.

This means two things: first, interest only loans start off with much lower repayments, because you're only paying the interest. Second, eventually, those repayments jump right up, because you have to pay more towards the principal. This is to make up for the initial interest only period of the loan, where you paid down no principal.

What are the risks of interest only loans?

Interest only loans can be considered risky because the principal is the main part of the loan. If you're not repaying the principal, you're not making progress towards owning more of your home and building home equity. You're essentially borrowing money without actually paying it back (until you start paying off the principal).

Investors do this in the hope that the market will grow and the property will increase in value over time, building their equity along the way.

Let's compare two otherwise identical loans, one with principal and interest payments, the other with interest only repayments for the first two years.

Interest only loan repayments end up more expensive over time

In the scenarios above opting for interest only repayments for two years will cost you $10,051 extra in interest.

If you prefer to understand tricky financial concepts visually, here's an infographic breaking down two borrowers with different interest only loans and one borrower with a principal and interest loan. As you can see, the longer your interest only period is the more interest you pay in the end.

What are the benefits and risks of interest only home loans?

• Lower repayments. Interest only loans are cheaper at first. If you're struggling to make repayments this loan type can be helpful.
• Enter the market sooner. An interest only loan makes your borrowing costs cheaper. For some borrowers, this makes an interest only loan an affordable way to enter the market. A principal and interest loan might make your repayments too expensive. This can be a risky option if you can't afford the higher repayments and you're banking on a pay increase to do so, as your home loan repayments will increase eventually.
• Tax savings. If you're an investor, your interest costs are tax-deductible, but payments towards the loan principal are not. This makes interest only loans popular with investors, who can get rental income and watch their property (hopefully) grow in value while their loan costs can minimise their yearly tax bill.

But the risks of interest only loans need to be considered:

• No equity. If your property doesn't grow in value, you won't build any equity if you're not repaying any of the principal. You could end up in negative equity.
• Revert rate. Repayments will jump up when the loan reverts to principal and interest. If you get caught by surprise this could be a painful adjustment, although, there is the prospect of refinancing to access a cheaper interest rate or better deal.
• Higher interest rates. Interest only mortgages usually come with higher interest rates than principal and interest loans. Of course, the repayments are still lower because you're not paying back the loan amount yet.

For the well-informed, well-organised borrower an interest only loan can work well. But if you don't know what you're doing it can get messy.

What kind of borrowers choose interest only loans?

Every individual borrower has their own reasons for choosing a certain type of loan. But there are certain types of borrower who have the most to benefit from interest only repayments.

• Investors who want to minimise their tax bill. Property investors in Australia can deduct their investment loan interest costs from their tax. If you are just paying interest on a loan then the entire borrowing cost for your investment is tax-deductible. This can be a real benefit for an investor who is receiving rent and paying less tax. They may choose to focus on repaying the loan on their family home (which has no tax benefits) and repay the investment loan principal later.
• Property flippers. Some investors think they can sell a property at a profit after just a few years. They decide to use an interest only loan and then sell the property quickly. They minimise their costs and never repay the loan, but by selling at a profit they can come out ahead. This can work in a booming market, but it can be a bit of a gamble.

Read more about how investors can make use of interest only mortgages.

• Borrowers who need a break. Sometimes things don't go as planned. People get sick, people lose jobs. Unexpected expenses come out of nowhere. If you are struggling to make repayments, your lender may let you switch to interest only repayments until you get back on your feet. This can cost you more in the long run, but if it keeps you making your repayments to the lender it can be worth it.

How to compare interest only loans to find the best one for you

Every borrower wants the best home loan. And it's a complex question. You can read our full best home loans guide if you want some tips for getting the best deal possible.

And it's important to remember that the best loan looks different for every borrower. It depends on your financial situation, your goals, your spending habits and your appetite for risk (or desire for certainty). There are also more factors such as the interest rate (the lower the better) and fees (the fewer and lower the better).

All of this is especially true for interest only loans, which are more complicated and potentially riskier than principal and interest loans. Here's what you need to do to find the best interest only home loan for you:

• Compare and get a low rate loan. Every borrower benefits from a more competitive interest rate because it makes your repayments lower. It's not the only factor you need to focus on, but the best interest only loan for you will have a rate that's lower than most.
• Find a loan with the right features. What features you need in an interest only loan depend on your goals and strategy. If you have extra cash lying around (or just some savings) you can use a 100% offset account to save on interest charges. But if you're an investor and you have an owner-occupier loan as well, you may want to save your money there instead (because interest on investment loans is tax-deductible). Some borrowers benefit from extra repayments, allowing them to repay their loan faster.
• Add up the fees. Some loans slug you with monthly fees, which can add up to a few hundred dollars a year. Others come with a hefty one-off application fee while others have no fees at all. If you can avoid fees, why not avoid them? But if there's a better loan for you with a $200 fee attached it could still be a better deal than a worse loan with no fee. Compare the entire loan not just the fees.
• Choose your lender carefully. The best interest only home loan depends partly on the lender. Different lenders have different ways of evaluating your loan application and different risk appetites. One lender will give you a significantly larger loan amount than another. When it comes to managing your loan once you've got it, a lender with a great online banking system or a handy smartphone app will make life much easier. Research lenders as much as you can before applying.

Tips for managing an interest only home loan

Borrowers with interest only loans need to pay careful attention to their home loan. To help you stay on top of your mortgage, here are some tips.

Tip no.1: Understand when the interest only period ends

No interest only loan remains an interest only loan forever. It eventually must revert to a principal and interest loan, otherwise you'd never repay it. You need to understand how long your interest only period lasts for. It could be two years or it could be four. If you don't know or can't remember, check with your lender.

You can prepare for the end of the interest only period by using a loan repayment calculator and checking how much your repayments will increase with principal and interest repayments.

Note that your interest rate will change when the interest only period ends. Fortunately, it should go down because principal and interest loans have lower rates in almost all cases.

Check your new rate anyway when the time comes. If it's not competitive you should consider refinancing to a better deal if you can.

Tip no.2: Repay more than the monthly minimum before you have to

One way to get ahead on your interest only home loan is to make extra repayments on top of the monthly minimum your lender charges you. Now, you can only do this if your loan allows for extra repayments (if you have a fixed rate loan you might not be able to).

You could try slowly repaying more than the minimum amount each month and slowly build up to the full amount you'll be paying once you switch to principal and interest repayments. This will take away the sudden shock of having your repayments increase massively.

If you're a property investor trying to minimise your non-tax-deductible costs then making extra repayments probably isn't the best use of your money. You might be better off repaying your owner-occupier home loan if you have one or putting the money in an offset account.

Tip no.3: Talk to a mortgage broker

A mortgage broker can answer tricky loan questions and help you structure your interest only loan in the way that works best for you.

They can offer you some tips for staying on top of your interest only loan too.

Is it harder to get an interest only home loan now?

APRA's limits on interest only lending have been lifted, but lenders are still careful when assessing interest only borrowers.

Maximise the chances of getting your application approved by:

• Saving a bigger deposit. Many banks are more willing to consider an interest only home loan if you have a lower loan to value ratio (LVR). A bigger deposit, usually at least 20%, will make you a more attractive borrower. Check out our detailed guide to saving a home loan deposit.
• Making a plan. Lenders will want to know why you want an interest only home loan instead of a principal and interest loan. If you can explain your justification for the loan and demonstrate your investment plans, you'll be in a much better position.
• Talk to a mortgage broker. A broker's job is to help you find a loan that suits your needs and financial situation. The broker vets your application before the lender does, maximising your chances of approval.

Detailed guide to home loan applications and paperwork