You may be considering an interest-only home loan because of lower initial repayments. Check the pros and cons before going ahead. Make sure you can afford higher repayments at the end of the interest-only period.
How interest-only home loans work
On an interest-only home loan (mortgage), your repayments only cover interest on the amount borrowed (the principal). For a set period (for example, five years), you pay nothing off the amount borrowed, so it doesn’t reduce.
At the end of the interest-only period, the loan will change to a ‘principal and interest’ loan. You’ll start repaying the amount borrowed, as well as interest on that amount. That means higher repayments.
Calculate your repayments after the interest-only period
Work out how much your repayments will be at the end of the interest-only period. Make sure you can afford the higher repayments.
Give yourself some breathing room. As interest rates rise, your loan repayments will go up even more.
Use the interest-only mortgage calculator
Work out your repayments before and after the interest-only period.
Pros and cons of an interest-only loan
Pros
- Lower repayments during the interest-only period could help you save more or pay off other more expensive debts.
- May be useful for short-term loans, such as bridging finance or a construction loan.
- If you’re an investor, you could claim higher tax deductions from an investment property.
Cons
- The interest rate could be higher than on a principal and interest loan. So you pay more over the life of the loan.
- You pay nothing off the principal during the interest-only period, so the amount borrowed doesn’t reduce.
- Your repayments will increase after the interest-only period, which may not be affordable.
- If your property doesn’t increase in value during the interest-only period, you won’t build up any equity. This can put you at risk if there’s a market downturn, or your circumstances change and you want to sell.
Managing the switch from interest-only to principal and interest
It can be a shock when the interest-only period ends and your repayments go up. Here are some tips to help you manage the switch to principal and interest.
Gradually increase your loan repayments
If your loan lets you make extra repayments, work up to making higher repayments before the switch.
Check when your repayments will go up and by how much. If they will go up by $1,200 a month in a year’s time, start paying $100 more each month now.
Get a better deal on your loan
You may be able to get a better interest rate. Use a comparison website to find a lower rate for a similar loan. Then ask your lender (mortgage provider) to match it or offer you a cheaper alternative.
If your lender won’t give you a better deal, consider switching home loans. Make sure the benefit is worth the cost.
Talk to your lender
If you’re worried you can’t afford the new repayments, talk to your lender to discuss your options. You may be able change the terms of your loan, or temporarily pause or reduce your repayments.
Get help if you need it
We can help you make a plan and negotiate with your lender.
Case Study
Jasmine considers an interest-only home loan
Jasmine finds an apartment to buy and looks at different loans online. She wants to borrow $500,000, to repay over 25 years.
She considers whether to get a loan with an interest-only period of five years, or a principal and interest loan.
Using an interest-only mortgage calculator, she compares the two. She uses a comparison rate of 4.8%.
The initial monthly repayments on the interest-only loan are $2,010. These increase to $3,250 at the end of the interest-only period.
Jasmine likes the idea of starting with lower repayments. But she realises she won’t be able to afford the higher repayments later.
She decides that a principal and interest loan, with constant repayments of $2,875, will work better for her.
Speak to us today for more help.
Source: Reproduced with the permission of ASIC’s MoneySmart Team. This article was originally published at https://moneysmart.gov.au/home-loans/interest-only-home-loans
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