Interest only home loans can be an effective strategy, but what are the benefits and pitfalls and how can you find the right option for you?
An interest only home loan is when borrowers only have to pay the interest as well as any fees for a fixed period of time, usually five to 10 years. If you only pay the minimum, then the amount you owe will not change.
During this period, the repayments are a lot lower compared to a principal and interest home loan where each repayment is made up of an interest and a principal component. Once the interest-only period ends, the home loan will revert back to a principal and interest home loan over the remaining term.
Do it yourself
See what your repayments would be for an interest only home loan with our Loan Repayments Calculator.
Smaller repayments: The minimum you are required to pay is lower during the interest only period. This can be beneficial if you are:
- Currently on a tight budget
Lower repayments will take the pressure off in the short term but you know you will be in a better financial position down the track. For instance, you are back to one income after the birth of a child, with your partner returning to work in 2 years’ time.
- Wanting to build your savings quickly
This may be to fund to purchase another property, for renovations or make lifestyle purchases like a holiday, caravan or boat.
- First time investor
If you are keen to purchase your first investment property but don’t want to commit to higher repayments until you have the extra expenditure required under control.
- Looking to invest elsewhere
Some people choose to put their extra cash towards other investments to help build their wealth like purchasing shares and managed funds. It also allows more diversification of assets outside the family home.
- Wanting to build an emergency fund
To get into the property market, many home buyers use up all their savings to pay for the deposit and expenses involved like stamp duty. This leaves nothing spare for the unexpected like losing your job, illness or major unexpected expense. Interest only repayments initially can allow them to build their savings back up more quickly.
- Currently on a tight budget
Tax deductible: Investors often have an interest only home loans which means that the full out of pocket expenditure will be a tax deduction. This is because it is only the interest amount that is deductible as it is the cost of funds used to purchase the property. Any principal paid builds the equity which is capital and not an expense.
Did You Know?
Many financial advisers will often say that if you have spare cash, paying down personal, non-tax deductible debt should be a priority. So by paying interest only on the investment loan, it allows borrowers to put extra money towards their non-tax deductible debts. Extra payments are then put towards paying off the loan on their own home, credit card and personal loans.
Get your foot in the door sooner: As mentioned above, interest-only home loans may give buyers an opportunity to purchase a property without being initially overwhelmed with the full principal and interest repayments. If the property needs improvements the extra amount could go towards it.
An interest only loan could be an option for those who want to ease their way into getting used to repayments on a home loan. It is advisable to increase your repayments to the principal and interest amount as soon as possible so that once it reverts to principal and interest you are already used to paying more and have a buffer built up for emergencies.
Keep options open: A principal and interest loan is almost like a forced savings plan. The principal amount you pay is locked away and can’t be accessed. As this builds up, you are growing your equity but can’t access it unless you increase your loan or sell the property.
What to be cautious about?
Some people like the idea that they can have ready access to anything that they pay above the minimum interest amount. This would only be a strategy for someone who was disciplined with their money because if you just fritter your cash away, the aim to have your house fully paid off by the time you retire won’t happen.
Without planning, you may face financial stress: If you have stretched yourself financially and taken out a loan that is close to the maximum you can lend, having interest only repayments at the start may make things a lot more difficult when they revert to principal and interest.
At the end of the interest only term, the full principal and interest amount is spread over the remaining term. This means that they will be higher than what you would have paid if you had principal and interest from the start.
To illustrate, on a $350,000 loan over 25 years at 4.25%:
- Principal and interest repayments $1,896 per month.
- Interest only repayments would be $1,240 per month, which is significantly less.
If the loan was interest only for 5 years, then the principal and interest repayments to pay it off over the remaining 20 years would be:
- Principal and interest repayments $2,167 per month.
This is a significant jump of $927 per month which could create havoc with your budget. It is also $271 higher than principal and interest repayments from day 1.
If you have financially stretched yourself to purchase the home of your dreams, you may also find that if interest rates fluctuate, your repayments could end up being significantly higher than the example above.
May pay more in interest: The longer you have your home loan for and the longer it takes to repay the principal owing; the more interest you will pay. By having an interest only period during your loan term, even if you revert to principal and interest repayments after, you will end up paying thousands of extra dollars in interest.
You don't build equity: By only paying interest for the first five to 10 years, you will not have any equity built up in your home. So, if you want to sell before the interest only period ends, you will still owe the full value of the mortgage. Also, if you decide to buy another property, you will not have the advantage of using equity saved in your current home to go towards that purchase.
Shortfall if you sell: If you are not paying off the principal, then you are really relying on an increase in the value of the property to build your equity. If you have borrowed a high proportion of the purchase price as can be the case for investment properties, then if value hasn’t increased, you could be looking at a shortfall if the property has to be sold. This would be the case if the sales proceeds were not enough to payout the loan on the property.
Higher interest rate: With changes to investor lending, some lenders have a higher interest rate for interest only loans even if it is for your own home. If this is the case, you need to weigh up the benefit of going interest only or shop around for a cheaper interest only interest rate.
Key questions to ask yourself
- Will I be able to afford the larger principal and interest repayments down the track?
- Will the overall costs outweigh the benefits of the initial lower repayments?
- What will your personal and financial situation be like in 5-10 years?
Some lenders have a split home loan option where borrowers can divide the amount owing into multiple portions. The benefits of both interest only and principal & interest portions include:
- Lower repayments during the first 5-10 years of the home loan.
- The amount owing will still be reduced.
- You will still build equity on your property, which you could use down the track if you want to refinance or purchase another property.
Offset accounts may come in handy
An offset account allows you to save interest on your loan without having to pay the funds into the loan itself. This can be very handy from a tax perspective as allows you to reduce the interest charged but doesn’t jeopardise the tax deductibility of an investment property loan. So for example, if you didn’t have any personal debt to pay down, you can still put your savings into the offset account to get the benefit of reduced interest on an investment property loan. If these same funds were paid into the loan and redrawn, it would reduce the amount of the loan that was tax deductible.
This can also be handy for your own home that you intend to turn into an investment property. By having interest only repayments and putting your spare funds into an offset account, you keep the amount you owe at its maximum but still reduce interest you are paying. When you turn it into an investment property down the track, the full loan will be tax deductible. If you are considering this strategy, then always discuss your options with a licenced adviser to ensure it is the best for your individual circumstances.
If you are coming to the end of the interest only period, you will need to think about what step to take next. Depending on the investment strategy, investors in particular can be reticent to change to principal and interest repayments. The options available include:
- Extend the interest only period: Some lenders may allow you to extend the interest only period. However, the lender may have to complete another credit assessment.
- Refinance to another lender: Take out a new loan with new interest only period.
- Allow it to revert to principal and interest repayments. Start working on paying off your loan over the remaining term
If you do want to extend the interest only period, you should start to organise your finances around 3 months ahead of time. This is to allow for the time to consider your options and do what is required to extend or refinance your loan.
Brooke is a first home buyer who took out a $350,000 home loan over 25 years at 4.25%. She opted for the maximum interest-only period that the lender offered which was 10 years. After 5 years she planned to rent the property out and move back in with her parents to fast track saving for a deposit on a unit closer to the city.
During the 5 years she made the principal and interest repayment of $1,896, but only paid the interest amount on the loan $1,240 and the remainder $656 in the offset account. By the end of the 5 years she had amassed almost $40,000 and was well on her way to saving a deposit for a unit.
She rented the property out for $350 per week, which meant that she had a shortfall of $160 per week to pay on the loan. She was able to claim the interest as a tax deduction on the $350,000 loan.
- Have a plan: As illustrated above, there are lots of reasons why you would choose an interest only home loan. But you need to have a plan as to what you want to achieve and stick to it. Without discipline, you could end up not making any inroads into what you owe and pay a lot more in interest along the way.
- Shop around: Just like any type of home loan, the more research you can do, the better. Compare interest only interest rates across a number of lenders to ensure that you are getting a good deal.
- Work out what features you need: Decide what features are important to you and compare loans with these features. Compare interest only terms that are offered, whether they allow you to pay extra and redraw for free, whether you can split the loan, whether you can time your repayments so that they come out when you are paid or whether it has an offset account.
- Pay extra into an offset account: Any money that is put into an offset account will reduce the amount of interest you have to pay on the loan. It is also a great way to get used to higher repayments when your home loan reverts back to principal and interest.
- Be prepared: At the end of the interest only term, know exactly what you want to do in advance so that you are not thrown into financial turmoil.
State Custodians has a range of interest only home loans. To find out if an interest only loan would be suitable for you, give our Lending Specialists a call on 13 72 62 or leave your details here to contact you.