More expensive in the long run
An interest-only home loan is a type of loan where your repayments only cover the interest on the amount you have borrowed, during the interest-only period. There is no reduction in the principal.
This type of home or business loan will have lower repayments in the short term and may provide greater tax deductions on an investment property, but will be more expensive in the long run. Here we explain the risks and benefits of interest-only mortgages.
How do interest-only loans work?
Most home and business loans are ‘principal and interest’ loans, which means your repayments reduce the principal (amount borrowed) and cover the interest for the period.
With an interest-only loan, you only pay the interest on the amount you have borrowed.
These loans are usually for a set period (for example, 5 years) after which the loan changes to a principal and interest loan. Interest rates on interest-only loans are often higher than for standard principal and interest loans.
Before you take out an interest-only home or business loan, work out how much the repayment will be at the end of the interest-only period to make sure you can afford the increased amount.
Case study: Peter and Jess get an interest-only loan
Jess and Peter took out a $500,000 home loan over 30 years, with an interest-only period of 5 years. They planned to reduce the interest on the loan by putting their savings into an offset account.
Two years into the mortgage, they decided to travel overseas for a few months and used the money in their offset account to fund the trip. When they returned home, they realised they’d run up quite a big credit card debt. Paying off the credit card meant they no longer had money to put into their offset account. With no money in their offset account, their interest repayments increased.
When the interest-only period ended, they still owed $500,000 but only had 25 years left to pay it back. Their repayments were suddenly a lot higher and they struggled to keep up with all their bills.
Risks of interest-only loans
Interest-only home loans seem more affordable because initially the repayments are lower than the repayments on principal and interest loans, but they have some drawbacks.
- Interest-only loans cost more – The amount of money you owe does not reduce during the interest-only period, which means you’ll pay a lot more interest over the life of the loan, compared to a principal and interest loan. For example, a $500,000 loan over 25 years, with an interest rate of 5%, would cost you an extra $40,062 in interest if it was interest-only for the first 5 years.
- Repayments will increase at the end of the interest-only period – When the interest-only period ends you’ll need to start repaying the principal as well as the interest – and, with less time to pay it off, your repayments are likely to be a lot higher.
- Not building equity – If your property does not increase in value during the interest-only period, you risk having no equity in your home at the end of this period, despite making payments every month. This may put you at greater risk if there is a downturn in the market or your circumstances change and you have to sell.
Case study: Zana’s interest-only loan repayments
Zana found her dream apartment and was looking at different loans online. She wanted to borrow $500,000 and repay it over 25 years. Comparison rates at the time were around 5% per annum.
Zana compared a loan with an interest-only period of 5 years to a standard principal and interest loan. The interest-only loan would make her repayments much lower in the short-term but she was worried she might not be able to make the increased loan repayments when the interest-only period ended.
Zana used to compare the two loans.
Initial repayments on the interest-only loan were $2,083 per month, increasing to $3,300 a month at the end of the interest-only period.
Zana didn’t think she could afford the increased monthly repayments when the interest-only period ended and decided that a principal and interest mortgage, with constant repayments of $2,923 per month would suit her better in the long term.
Benefits of interest-only loans
Interest-only home loans can provide some short-term benefits, including:
- Lower repayments at the start of the loan – This may help you maximise the amount of money you can borrow or give you the opportunity to pay off other high-interest debt.
- Maximum tax deductions – Investors sometimes choose an interest-only loan to increase their tax deductions, which reduces their tax payable.
- Management of short-term lending needs – These loans are useful for transitional borrowing needs, such as bridging or construction loans.
How to manage when an interest-only loan changes to a principal and interest loan
Interest-only loans usually have a set interest-only period, after which the loan becomes a standard principal and interest loan. When the loan switches over, you will have to start repaying the principal as well as the interest, which can greatly increase your loan repayments. Here are some tips to help make the transition easier.
Gradual loan repayment increase
If your loan allows you to make extra repayments, you may find it easier to increase your repayments gradually in the lead up to the switch to principal and interest.
For example, if your loan repayments will increase by $1,300 a month, you could increase your repayment by $100 a month in the 13 months before the switch.
Loan repayment increase fast approaching
If your mortgage repayment is about to increase significantly and you’re worried you can’t afford the new repayments, here are some things you can do:
- Re-do your budget – Reviewing your may help you find savings elsewhere that could soften the blow.
- Ask for a reduction in your interest rate – Use a Finance and Mortgage Broker or use a mortgage calculator to see what loans are available from different credit providers and ask your lender to match a lower rate for a similar product.
- Refinance your loan – If your lender won’t offer you a better deal you might consider switching home loans. Be aware that switching home loans could extend the life of your loan and/or you may have to pay lender’s mortgage insurance (LMI) again, which could cost you more in the long run.
What if you can’t afford your increased loan repayments?
If your interest-only loan has already changed to principal and interest and you can’t afford the repayments, contact your lender immediately to negotiate a repayment plan. Here are some options you can ask for:
- Extend your loan period, so you make smaller repayments over a longer time
- Postpone your repayments for an agreed period
- Extend your loan period AND postpone your repayments for an agreed period.
When negotiating a repayment plan, make sure you can afford it. There is no point agreeing to an amount that is unaffordable.
Taking action straight away can stop a small problem becoming a big one. Most banks have hardship officers who can assess your situation and work out what help is available.
If you’re considering an interest-only loan, think carefully about whether it’s the right loan for you.
Give us a call or drop us an email and our friendly and helpful staff with assist you.
This blog post is for general information purposes only and is not intended as financial or professional advice. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product or other professional advice. You should seek your own independent financial, legal and taxation advice before making any decision about any action in relation to the material in this article.