Whether you're refinancing to an interest-only loan or switching from interest only to principal and interest repayments, here's what you need to know.
But interest-only loans are risky because you're not really paying your loan off until you start paying back the money you've borrowed. So if you're thinking about refinancing to an interest-only mortgage, or are trying to leave one, you really need to know how these loans work.
Interest-only home loan comparisons
I want to switch to an interest only loan
Interest-only loans are suited to the specific needs of a certain few borrowers (and mainly property investors). Due to this, there are only a few situations when it's beneficial to refinance an interest-only loan.
Reducing your repayments in the short term
Switching from principal and interest to interest only payments will drastically reduce your loan repayments: for now. This is because you only have to pay the interest charged on top of the loan. But over time you will end up paying a lot more because you're paying more interest and delaying the repayment of the money you've borrowed.
Borrowers who are struggling to make repayments may find some relief in refinancing to interest only payments. But it's important to understand that in the long term it's costing you more.
Also, you could try asking your current lender to switch your loan to interest only payments. This can be easier than refinancing.
To take advantage of investor tax benefits
Interest only loans are popular with property investors, partly because of tax benefits. As an investor you can deduct the interest paid on your investment loan from your tax bill. This is something you can't do as an owner occupier, however.
Some investors also try to hold an investment property for only a few years while hoping for large capital gains. This can work if you buy the right property in a booming market (although it's a risky strategy). In this case, refinancing to an interest only loan makes sense because it's cheaper. You're not worried about repaying the loan because you're planning to sell the property in a short period of time.
I want to switch from interest only to a principal and interest loan
This is a more common scenario and has a number of benefits. With a principal and interest loan you can:
- Pay off your debt and build equity. Once you start paying off the loan principal you own more of the property. You're building equity and wealth for the future.
- Access lower rates and more mortgage features. Interest only loans usually have higher interest rates and fewer mortgage features such as offset accounts. This means you can get a more competitive loan with useful features.
But there are a couple of things to watch out for when leaving an interest only loan:
- Your repayments will increase. Principal and interest repayments are much higher than interest only repayments. Be prepared for this increase in costs by looking at a loan repayment calculator, assessing your income and spending and doing a budget.
- You might not have much equity. If you've only been making interest only repayments then you haven't built equity. This makes it harder to refinance. If you started with a 20% deposit and your property hasn't lost value you should be safe. But if you started with a small deposit and haven't repaid any mortgage principal you may need to pay lenders mortgage insurance. This is a premium borrowers pay when borrowing more than 80% of their property's value. It can be quite expensive.
Still confused about interest-only refinancing? Speak to a mortgage broker
Mortgage brokers can help you find a new loan when you're in a complicated situation. And this includes interest-only refinancing. They can advise you on the right course of action and help you avoid making a costly mortgage mistake.