Interest only home loans explained

We explore how interest only home loans affect home loan repayments

23 March 2022|5 minute read

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There are many factors to consider when you’re searching for the right home loan.

Choosing between different types of loans and home loan features can get confusing. That’s why we’re here to help clear up the home loan confusion.

In this article, we explore what interest only home loans are, the advantages and disadvantages and an example of how an interest only loan can affect your home loan repayments. 

What is an interest only home loan?

Home loans typically consist of two parts – ​​the principal (the total amount you borrow) and the interest (the cost of borrowing money, charged as interest on top of your principal). 

An interest only home loan requires the borrower to only make repayments on the interest accumulated on their loan, rather than the principal loan amount. 

Interest only loans have a fixed period (for example, 1-5 years). When this period ends, the loan will typically revert to a principal and interest (P&I) loan, usually at your lender’s standard variable rate. 

This means your repayments will increase so that you start paying down the principal amount as well as the interest accruing on the principal. 

Who are interest only home loans typically suitable for?

Interest only home loans are usually best suited to property investors rather than owner occupiers. This is because this type of loan allows you to delay paying off your principal amount for a period of time, reducing your outgoing expenses. 

Investors can use the extra funds to maximise their investment opportunities. For example, some investors will buy a property in a high growth suburb and sell it in a few years for a profit after the property’s value has increased. This is also known as capital gain and this profit may be subject to capital gains tax (CGT).

Interest only home loans are also helpful for investors who choose to use a negative gearing strategy. 

Negative gearing is when the expenses of an investment outweigh the investment income, creating a negative cash flow. 

These short-term losses are expected to be offset by significant capital gains in the long run as the investment increases in value for the investor to sell at a profit. These losses may also be tax deductible.

This strategy is most commonly used for investments in high growth suburbs or metropolitan areas. 

Additionally, investors can benefit by also claiming their interest repayments as tax deductions, something that owner occupiers can’t do. 

Not all home loan borrowers will be eligible for an interest only loan. If you’re wondering if this could be the right type of loan for you, get in touch with your broker to discuss your options.  

What’s the difference between interest only and principal and interest repayments?

Interest only home loans only require you to pay the interest charged on your principal. This means your principal amount stays the same during your interest only period.

On the other hand, principal and interest home loans require you to pay the interest charged on your principal, as well as your principal. This means each time you make a repayment, you chip away at your loan amount, reducing your interest charged in the process. 

Interest rates for interest only loans are typically higher than interest rates that are offered for P&I loans.

How does an interest only home loan affect your repayments and interest?

Let’s say you have an outstanding loan balance of $300,000 and a loan term of 28 years. 

In scenario 1, you decide to go for an interest only home loan. Remember, interest rates on interest only loans are typically higher than principal and interest loans. 

You enter into an interest only loan with a 2.99% interest rate for a 5 year fixed term. Your monthly repayments over this period are $747.50. 

At the end of the fixed period, your loan reverts to a P&I loan with an interest rate of 2.19% and your monthly repayments increase to $1,384.

At the end of your 28 year home loan term, you would have paid a total of $126,989 in interest.

In scenario 2, you decide not to go on an interest only loan and choose a principal and interest loan with an interest rate of 2.19%. 

Your monthly repayments turn out to be $1,195. At the end of your 28 year loan term, you would have paid $101,587 in interest.

That’s an additional $25,402 of interest paid over the life of your loan if you were to get an interest only loan for the first 5 years of your loan term. 

How long can you have an interest only home loan?

You can only be on an interest only home loan for a fixed period of time. This is because you only repay the interest that accumulates on your principal – and you’ll have to pay off your principal amount eventually.

Lenders typically offer interest only home loans for a period of around 1 to 5 years, but this will vary between lenders.  

Can you extend an interest only home loan? 

Yes, it’s possible to extend your interest only loan period if your lender is comfortable doing so. 

Simply make a request with your lender or speak to a broker to get in touch on your behalf. 

If you’re seen as a low risk borrower and have consistently made your interest repayments on time, you’ll have a better chance of being approved for an extension. 

Be mindful that some lenders may be hesitant to extend your interest only loan, as this means you’ll either have to significantly increase your repayments when you revert to a P&I loan or you’ll need to extend your overall loan term.

If your current lender won’t approve you for an extension, there’s a chance you’ll be able to extend this interest only period by refinancing your loan with another lender. 

What are the advantages of an interest only home loan?

  • Lower repayments during the interest only period
  • Can align with investment strategies focused on buying properties to sell in a few years after the property has experienced value growth
  • Claim higher tax deductions if you’re an investor.

What are the disadvantages of interest only home loans?

  • Interest rates are typically higher for interest only loans
  • Your principal amount doesn’t decrease during the interest only period 
  • Your repayments increase after the end of the interest only period and will be higher than repayments if you had never gone on an interest only loan (due to the decreased loan period) 
  • You’ll end up paying more interest over the life of your loan.
  • If you rely on the potential value-growth of a property in the short term, you could be disappointed if property prices aren’t in your favour.

Wondering if an interest only home loan could be right for you? Clear up the confusion by getting in touch with an Aussie Broker at a time that suits you.

Book a chat with an Aussie Broker

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