Beginner’s guide to interest-only home loans

Dominic Beattie By on August 22, 2019
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Photo by Eddy Klaus on Unsplash

In recent years, interest-only home loans accounted for around 40% of all outstanding Australian mortgages.

That was before regulatory bodies introduced measures to slow down this form of lending. The Australian Prudential Regulation Authority (APRA) imposed a 30% restriction on the number of home loans issued by banks that could be interest-only.

These restrictions were initially put in place in March 2017, and interest-only lending fell as a result, but as of January 1 2019, these restrictions have been lifted, and institutions like ANZ were quick to capitalise by loosening their lending criteria for interest-only loans.

APRA Chairman Wayne Byres said the restrictions imposed on interest-only lending was always going to be temporary.

“APRA’s lending benchmarks on investor and interest-only lending were always intended to be temporary,” Mr Byres said.

“Both have now served their purpose of moderating higher risk lending and supporting a gradual strengthening of lending standards across the industry over a number of years.”

Graph showing difference in borrowing costs between owner-occupier and interest-only loans widening after APRA's restrictions.
Source: Reserve Bank of Australia

There’s now a cloud looming on Australia’s economic horizon in the form of $360 billion worth of these loans that are set to ‘expire’ over the next three years, upon which they’ll transition into the standard principal and interest repayment format.

Source: Digital Finance Analytics, The Project

There are some concerns that many of the borrowers of these loans will be unable to meet the significantly higher repayments that will kick in, possibly prompting a mass sell-off of property.

Given these concerns, it’s likely some borrowers don’t fully understand interest-only home loans and the risks they entail.

So if you’re considering an interest-only loan, read on to learn about what they are, the risks and benefits, what happens when they expire and how much more they can cost you over the life of your loan.  

What is an interest-only mortgage?

Interest-only (IO) loans are home loans which delay the repayment of the borrowed amount (the ‘principal’) for a fixed term, usually between three and five years. During this time, you only have to pay the interest on your loan, not the principal. At the end of that set period, the repayments transition to paying off the principal as well as the interest.

An interest-only loan term is usually the same length as a standard home loan – around 30 years. However, instead of paying principal and interest for the full 30 years, you have the option to pay just interest for the first five years, for example, and then pay substantially more for the remaining 25 years.

Interest-only home loans could be summed up as ‘less now’ but ‘more later’ in terms of the monthly repayments one has to make across the term of the loan.

Compare interest-only home loans 

Below is a snapshot of some of the lowest interest-only home loans available for both owner-occupiers and investors. The home loan rates shown are based on a loan of $400,000 for a 30-year loan-term, with an LVR (loan to value ratio) of 80%. Introductory rates and packaged home loans are not included.

Variable owner-occupier home loans (interest-only)

Provider Ad rate
p.a.
Comp rate*
p.a.
Monthly
repayments
 
Real Deal IO Special Offer 80% 3.32% 3.33% $1,107 More details
Low Rate Home Loan w/Offset 3.40% 3.42% $1,133 More details
Great Rate Discount Variable 3.57% 3.58% $1,190 More details
Budget Owner-Occupied IO 3.61% 3.49% $1,203 More details
Simplicity Plus Special Offer 3.92% 3.93% $1,307 More details
Ad rate
p.a.
Comp rate*
p.a.
Monthly
repayments
Real Deal IO Special Offer 80%
3.32% 3.33% $1,107
More details
Low Rate Home Loan w/Offset
3.40% 3.42% $1,133
More details
Great Rate Discount Variable
3.57% 3.58% $1,190
More details
Budget Owner-Occupied IO
3.61% 3.49% $1,203
More details
Simplicity Plus Special Offer
3.92% 3.93% $1,307
More details

Base criteria of: a $400,000 loan amount, variable, interest-only (IO) home loans with an LVR (loan-to-value) ratio of at least 80%. Introductory rate products were not considered for selection. Monthly repayments were calculated based on the selected products’ advertised rates, applied to a $400,000 loan with a 30-year loan term. Rates correct as at 2 October 2019. View disclaimer.

Variable investment home loans (interest-only)

Provider Ad rate
p.a.
Comp rate*
p.a.
Monthly
repayments
 
Smart Investor Home Loan IO 3.39% 3.43% $1,130 More details
Low Rate Inv Loan w/Offset 3.40% 3.41% $1,133 More details
Real Deal Inv Special Offer 3.59% 3.63% $1,197 More details
Inv Discount Variable IO 3.67% 3.69% $1,223 More details
Ad rate
p.a.
Comp rate*
p.a.
Monthly
repayments
Smart Investor Home Loan IO
3.39% 3.43% $1,130
More details
Low Rate Inv Loan w/Offset
3.40% 3.41% $1,133
More details
Real Deal Inv Special Offer
3.59% 3.63% $1,197
More details
Inv Discount Variable IO
3.67% 3.69% $1,223
More details

Base criteria of: a $400,000 loan amount, variable, interest-only (IO) home loans with an LVR (loan-to-value) ratio of at least 80%. Introductory rate products were not considered for selection. Monthly repayments were calculated based on the selected products’ advertised rates, applied to a $400,000 loan with a 30-year loan term. Rates correct as at 21 October 2019. View disclaimer.

Benefits and risks of interest-only mortgages

The decision to take out an interest-only mortgage should only be made after carefully considering the pros and cons (i.e. benefits and risks) involved. Some of these are outlined below.

Benefits of interest-only home loans:

  1. Lower repayments: The temporary lower repayments of an interest-only loan can free up money for other expenses like renovations or paying off other outstanding debts.
  2. Investment Strategy: Interest-only loans are great for investors who plan to profit by selling their properties within the IO period (eg. after making a capital gain) because it reduces their expenses (and relative cash outflows).
  3. Buying time: The reduced repayments effectively let people buy time through the delaying of higher repayments. Whether it be a temporary reduction of income (eg. someone taking 2 years off to study) or a temporary increase in expenses (eg. 2 years of higher school fees), if borrowers are confident of returning back to a level of income or expense ‘normality’ at the end of the interest-only term, then interest-only loans are a great way for them to effectively buy time and flexibility.

Risks of interest-only home loans:

  1. Pay more in interest: Since you’re not paying off the principal over the interest-only period, you’ll end up paying more interest over the life of your loan than someone who has been paying both principal and interest over the entirety of theirs.
  2. Higher interest rates (generally): Interest-only loans often have a higher rate of interest than principal & interest (P&I) loans. This isn’t the case for all lenders though.
  3. Repayment shock upon expiry: If you’re not prepared, the expiry of an interest-only period can come as a shock as the costs of repayments suddenly increase. The RBA reports that repayments could increase by around 30-40% as the principal is repaid as well as interest. For a typical interest only-borrower with a $400,000 30-year mortgage with a 5-year interest-only period, the RBA estimates this would equate to an extra $7,000 per year in repayments.
  4. Less equity: By only paying the interest portion of your repayments, you’re possibly (subject to property value movements) not building any equity in your property. Many investors in recent times have built equity through rises in the value of their properties, but if the value falls, you could end up owing more to the lender than what the property could actually sell for if indeed you were forced to sell the property.

How long can I take out an interest-only loan for?

Interest-only periods usually last between three and five years. Some lenders offer interest-only periods of up to 10 to 15 years, but this may be restricted to investors. You may be able to negotiate the length of the interest-only period with your lender, depending on your personal circumstances.

What happens when my interest-only loan expires?

When your interest-only loan period expires, your loan will roll over to principal and interest repayments. This means you’ll be paying off the outstanding mortgage as well as interest.

There are three main options you can pursue if your interest-only loan period is ending:

  • Extend the interest-only period: Lenders will want to keep their customers and may be willing to extend your interest-only period. This will probably be subject to a credit assessment and property valuation.
  • Refinance to another loan: If you’re nearing the end of your interest-only period, it might be a good idea to review your interest rate and finances before comparing other options in the market. Other lenders might be able to offer a better rate on a principal and interest loan than the rate of what your interest-only loan is rolling over to.
  • Ride out the expiry: If you’ve planned well and you’re confident that you’ll afford the P&I repayments (and you’re happy with your interest rate), riding out the expiry of the interest-only period and transitioning to the P&I stage of your current home loan is the most hassle-free option at your disposal.

Interest Only vs Principal & Interest: Cost difference example

Desmond and Rachael have both found houses to buy and decided to take out separate loans of $400,000 for 30 years. Desmond chooses a P&I loan, while Rachael opts to pay interest-only for the first five years before switching to P&I for the remaining 25 years.

For the purposes of this comparison, it’s assumed both Desmond and Rachael have the same interest rate of 4.0% which holds steady over the 30 years.

 LoanMonthly repayment during IO periodMonthly repayment after IO periodTotal cost (principal & interest) of the loan
Desmond (P&I)$400,000N/A$1,910$687,478
Rachael (IO)$400,000$1,333$2,111$713,404
Total cost difference $25,926

Source: Savings.com.au’s Loan Repayments Calculator

As shown in the table above, by only paying interest for the first five years of the mortgage, Rachael’s loan will cost her $25,926 more than Desmond’s over the 30 years.



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Interest-only home loans for owner-occupiers?

Interest-only loans can be a great short-term solution for property investors and owner-occupiers alike, however it’s important to remember that you will have to make principal repayments at some point down the track. Interest-only loans tend to have more benefits for property investors, while owner-occupiers (outside of what might be described as extraordinary circumstances) are generally better suited towards a standard principal and interest loan. Do your research and read the terms and conditions before making a purchase decision.

Frequently asked questions

1. Can you pay off an interest-only mortgage early?

Just as you can with a variable rate principal and interest mortgage, it is possible to pay off a variable rate interest-only mortgage early. This would typically involve either selling the house or making very large voluntary principal repayments.

2. How much deposit do I need for an interest-only mortgage?

Deposit requirements vary by lender, but like principal and interest mortgages, many lenders require a deposit of at least 5% of the property’s value. However, to qualify for some of the lowest rates and to avoid having to pay for LMI, you may need to have a deposit of at least 20%.

3. Can I get an interest-only mortgage with bad credit?

If you have bad credit, it will be more difficult to get any home loan, but it is possible. Here’s how to improve your chances of getting a home loan.

4. Can I switch to an interest-only mortgage from P&I?

Borrowers may apply to switch to interest-only payments from principal and interest, but this is subject to lender’s approval.

5. Can I pay a lump sum off an interest-only mortgage?

Many lenders allow variable rate interest-only borrowers to make lump sum repayments off the principal during the interest-only period, however, you may be required to fill out a form each time you want to do so.

6. Can I pay interest-only on a fixed mortgage?

Yes, there are many interest-only fixed-rate mortgages available. Fixed rate interest-only home loans are short-term home loan contracts that only require you to pay off the interest on the amount borrowed and pay at a fixed rate.

7. Is it worth overpaying an interest-only mortgage?

It’s only worth overpaying an interest-only mortgage if the excess funds go towards paying down the principal. As stated above, you’ll often have to inform your lender each time you wish to make a payment off the principal during an interest-only period.

8. Can I get an interest-only mortgage as a first time buyer?

Many lenders do offer interest-only mortgages to first home buyers, however, it’s important that first time buyers are fully aware of what interest-only loans are and how they work before applying for one.

9. Are interest-only loans more expensive or cheaper?

Interest-only home loans tend to have lower repayments in the short term and may provide greater tax deductions on an investment property, but generally work out to be more expensive in the long run. This is because the amount of money you owe doesn’t reduce during the interest-only period, meaning you’ll pay more interest over the life of the loan. Loan repayments also increase at the end of the interest-only period as you’ll need to start paying the principal.

10. Does interest-only mortgage affect credit rating?

Having an interest-only mortgage does not affect your credit rating any more than having a principal and interest mortgage.

Savings.com.au’s two cents

Interest-only loans can offer great opportunities to build cumulative wealth from buying and selling property in rising markets.

The flip-side to this opportunity is the risk that lies in getting caught when the market turns and profits do not materialise (or disappear).

In this (unexpected) situation, interest-only loans can harm wealth through increased repayments after the interest-only period and/or having to sell the property at a net loss due to values falling and an inability to service new larger repayments.

Interest-only loans can be a great short-term solution for property investors and owner-occupiers alike, but they tend to have more benefits for property investors, while owner-occupiers (outside of what might be described as extraordinary circumstances) are generally better suited towards a standard principal and interest loan.

Do your research and read the terms and conditions before making a purchase decision.


Disclaimers

The entire market was not considered in selecting the above products. Rather, a cut-down portion of the market has been considered which includes retail products from at least the big four banks, the top 10 customer-owned institutions and Australia’s larger non-banks:

  • The big four banks are: ANZ, CBA, NAB and Westpac
  • The top 10 customer-owned Institutions are the ten largest mutual banks, credit unions and building societies in Australia, ranked by assets under management in 2018. They are (in descending order): Credit Union Australia, Newcastle Permanent, Heritage Bank, Peoples’ Choice Credit Union, Teachers Mutual Bank, Greater Bank, IMB Bank, Beyond Bank, Bank Australia and P&N Bank.
  • The larger non-bank lenders are those who (in 2019) has more than $9 billion in Australian funded loans and advances. These groups are: Resimac, Pepper, Liberty and Firstmac.

In the interests of full disclosure, Savings.com.au and loans.com.au are part of the Firstmac Group. To read about how Savings.com.au manages potential conflicts of interest, along with how we get paid, please click through onto the web site links.

*Comparison rate includes both the interest rate and the fees and charges relating to a loan, combined into a single percentage figure. The interest rate per annum is based on a loan credit of $150,000 and a loan term of 25 years.

Dominic Beattie
Dominic Beattie is Savings.com.au’s Content Manager. He has been writing and editing articles on finance, business and economics since 2015, having previously worked as a Senior Journalist at financial research firm Canstar before helping to relaunch Savings.com.au in November 2018. Dominic aspires to help everyday Australians discover simple and effective ways to comfortably manage their finances and save money, without sacrificing their joie de vivre.
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