If you’re considering an interest-only loan, here are some pros and cons you need to know about. Find out the ins and outs here to see if it's fit for your needs.
What is an interest only home loan?
An interest only (IO) home loan is a type of loan where you’re only required to make payments of the interest portion on the loan, for a set period of time. This means that unlike a principal and interest (P&I) home loan, where you pay down the principal loan amount as well as the interest charged on the loan, you are not actually paying down your loan amount, so your repayments will be lower. Interest only loans typically have a maximum period of five years, after which the loan reverts to the normal principal and interest repayments.
Interest only home loans are not designed for everyone. For example, they’re not really a good idea for home buyers looking to pay less on their monthly repayments. If you can’t afford your monthly principal and interest repayments, you probably shouldn’t get the home loan. Plus, you’ll be charged a higher interest rate for the benefit of paying interest only, and you’ll end up paying lots more in compounding interest over the life of your loan.
However, interest only loans can be a useful strategy for property investors who can claim the interest charged as a tax deduction (paying more interest over the life of the loan, means more deductions), or buyers who only plan on holding onto the property for a few years before selling it.
The good stuff.
Lower monthly payments.
Because you are paying only the interest component on your home loan, your monthly payment will be comparatively lower.
For example, for a $400,000 P&I home loan over a 25-year term, and at an interest rate of 4.50% p.a., the monthly repayment would be approximately $2,224. This is compared to the monthly cost of approximately $1,500 for an interest only home loan at the same rate.
Home buyers should be wary of getting an interest only home loan simply because it is more affordable, as the loan will revert to P&I after the set time.
Maximising tax deductions.
An interest only home loan generally presents potential tax benefits to investors. If the interest paid on the home loan is a tax deduction the investor can claim, then paying interest only extends and maximises that deduction for the investor.
This is because paying off the principal balance means that interest would be charged on a smaller amount, which reduces the dollar amount of the tax deduction.
Some investors take out an interest only loan for an investment property, relying on the fact that the property will grow in value over time, which will be used to repay the principal amount at the end of the term.
Freeing up cash to invest elsewhere.
As an investor, paying interest only frees up extra cash to put towards something that isn’t tax deductible, such as another investment loan, business running expenses, or the cost of studying.
There are many different strategies to improve wealth over the long term, so there are plenty of ways to put that extra cash to better use, other than repaying the principal balance on an investment loan.
Using an offset account on an interest-only loan.
If you have an interest only home loan, you may choose to pay the difference in the repayment amount into an offset account, so the amount of interest paid is reduced, but you can still access the funds if you need to. If you keep dipping into the funds though, you won’t have much money to offset the interest payments, so you may be better off with a with a P&I loan instead.
The bad stuff.
Interest only loans have some distinct disadvantages over other types of home loans, which we’ve outlined below.
Not available from every lender, and they often come with a higher interest rate.
With lender’s tightening their lending policies, particulary for investors, it is harder to find lenders who offer interest only loans. And if you do, these days you’ll usually be charged a premium on your interest rate.
Higher cost, over the life of the loan.
Because you don’t reduce the amount of money you owe in your interest only period, you'll end up paying more interest over the life of the loan, compared to a principal and interest loan.
For example, for a $500,000 loan amount over a 25-year term, and with an interest rate of 5%, your would pay $40,062 more in interest with an interest only loan compared to a principal and interest loan on the same rate.
Your equity is reliant on an improving property market.
If your property doesn’t increase in value while you’re making interest only payments, you risk having no equity in your home even though you’re making repayments every month. This means if you have to sell the house quickly, you may end up losing money.
You’ll need to pay off your principal, eventually.
Once your interest only period ends, you will need to start making principal and interest payments. Unless you’re intending to sell the property within a few years, you’lll need to pay off the principal loan balance at some point.
When the loan does revert to a principal and interest repayment, the sudden surge in the cost of monthly repayments can be a shock. Unless there is a specific (and good) reason for you to be choosing an interest only loan, you could just be delaying – at your own cost – the inevitable. For more information about interest-only home loans, read up at ASIC’s MoneySmart.
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