Key Takeaway Table
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Definition
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An interest-only loan is a type of mortgage where you can pay only the interest for a short period. After this initial period, the loan will roll over to a regular loan, which means you'll be paying both principal and interest monthly.
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Pros of Interest-Only Home Loans
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The main benefit of an interest-only loan is the lower initial payments, which can improve cash flow. Investors in particular will use interest-only loans on investment loans while they prioritise paying down non-deductible debt.
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Cons of Interest-Only Home Loans
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Interest-only loans cost more over the life of the loan. The increase in repayments once the loan rolls over can also bring financial strain to borrowers. Moreover, you can risk not building equity during the interest-only period.
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Who are Interest-Only Loans Best For?
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Interest-only loans are more suited to investors and borrowers with specific short-term financial or investment goals. They are not typically recommended for the average homeowner looking to live in their home for a long period, due to the higher overall cost and the risk of payment shock.
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Tips for Transitioning from Interest-Only to Interest and Principal Payments
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Ensure that you plan early for the transition period to avoid repayment shock. Look for other streams of income and reduce discretionary income so you can comfortably make repayments. If you are allowed to, make early repayments on your principal during the interest-only period.
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There is a variety of home loan products available for Australians, with each serving a different purpose and catering to different individuals and their financial situations. One type of loan allows you to pay off only the interest for a short period, which can be beneficial to certain types of borrowers. Let’s take a look at what an interest-only loan is, how it works, and the pros and cons.
What is an Interest-Only Home Loan?
An interest-only home loan is a type of mortgage where the borrower pays only the interest for a set period at the beginning of the term. This period typically lasts for 1 to 3 years, although it can vary depending on the lender and the specific loan agreement. Some lenders may allow longer terms for investors. During this initial phase, the monthly payments are lower because they don’t pay off any of the principal amount borrowed.
After the interest-only period ends, the loan usually converts to a standard loan, making repayments increase significantly – this is because the borrower starts paying off the principal and the interest and doing so over a shorter period compared to if they had been paying principal and interest from the beginning. For instance, if your loan term is 30 years and your interest-only period is 5 years, your principal (plus interest) must be paid off in 25 years, which significantly increases your overall costs.
Example
Let’s say your loan is $500,000 payable in 30 years. If you apply for a standard principal and interest loan with an interest rate of 5%, your monthly repayments should be around $2,684.11 (in this example, let’s say the interest doesn’t change for the whole 30 years and you’re making the minimum repayment).
If you get an interest-only loan with the initial period set at 5 years, you’ll only be paying off $2,083.33 for the first 5 years. However, once the loan rolls over, you’ll be paying $2,922.95 in repayments. Overall, you’ll be paying $35,565.7 more in 30 years than with a principal and interest loan.
Pros of Interest-Only Home Loans
- Lower Initial Payments: The most significant advantage of an interest-only loan is the lower payment during the initial period - this can help with cash flow.
- Investment Strategy: Investors often use interest-only loans to maximise cash flow from rental properties. The lower payments can allow investors to allocate funds elsewhere, often to owner-occupied home loans or other non-deductible debt.
Cons of Interest-Only Home Loans
- Higher Overall Cost: Since you’re delaying the payment of the principal, by the time your loan switches, you’ll be paying higher repayments monthly than if your loan was a regular principal and interest loan from the start.
- Risk of Repayment Shock: Once the interest-only period ends, your repayments will increase significantly as you start paying both principal and interest. This can be a financial shock if you're not prepared for the higher payments.
- No Equity Built: If property prices do not appreciate during the interest-only period, you will not be building equity in your property because you’re not reducing the principal debt.
Who are Interest-Only Loans Best For?
- Property Investors: Those investing in real estate often prefer interest-only loans because the lower initial payments can improve cash flow. This strategy allows investors to allocate more funds to other investments or to non-deductible debt.
- Buyers with Short-Term Ownership Plans: Interest-only loans are a great option for buyers who plan to own the property for only a few years before selling, especially if they believe the property value will appreciate. This strategy can be riskier and relies on favourable market conditions.
- Borrowers with Other Investment Plans: Interest-only loans may suit borrowers who have a clear strategy for using their available cash for higher-earning investments. The idea is to use the money that would have gone toward principal repayments to invest elsewhere, aiming for earnings higher than the interest rate on their loan.
- Borrowers Going Through Transitional Periods: Individuals undergoing a temporary financial or life transition such as a career change might use an interest-only loan to lower their expenses in the short term, with a plan to switch to a traditional loan or sell the property in the future.
Who Should Be Cautious?
- First-Time Homebuyers: Generally, interest-only loans are less suitable for first-time homebuyers looking to live in their property. Without a clear strategy for managing the transition to full repayments or building equity in the property, they could find themselves facing financial stress once the loan switches to principal and interest payments.
Tips for Transitioning From Interest-Only to Principal and Interest Payments
Some lenders may allow loan refinancing or an extension of the interest-only period (subject to further assessments). If a borrower doesn’t take action during this time, the loan will automatically switch to principal and interest payments. Here are some tips to help you plan for this transition and successfully pay the significantly larger repayments:
Plan Ahead
Begin planning for the transition early in the interest-only period. Understand exactly when the switch will happen and what the new monthly payment will be, and start adjusting your monthly budget to accommodate the higher payments. You may need to review and reduce discretionary spending or find ways to increase your income to comfortably make the higher payments.
Extra Payments
Check in if you can make occasional extra payments towards the principal during the interest-only period. This will reduce the principal balance you’ll have to pay interest on later, effectively lowering the future payment amount and helping you build equity in the property.
Emergency Fund
Ensure you have an emergency fund in place. This fund can help you manage unexpected expenses without impacting your ability to make your mortgage payments.
Talk to Experts About an Interest-Only Loan
Interest-only loans can offer flexibility and cash-flow benefits under the right circumstances, but they can come with significant risks, especially if the market conditions change or if your financial situation worsens. It's important for anyone considering this type of loan to carefully assess their financial position, investment strategy, and long-term goals before applying.
Darkhorsefinancial.com.au can provide personalised advice based on your financial situation, help you adjust your financial plan, and explore options you may not have considered. Contact us today.
