Repayments for interest only home loans tend to be lower because you only pay the interest. For the right borrower this could be the best option, just as long as you know you’ll be paying more interest in the long run.
Having an interest only home loan enables you to lower your early repayments whilst having higher repayments further down the track. If you’re an investor looking to minimise the costs, this is probably the most popular option available for you. However, if you’re quite new to the investor life, maybe avoid this loan seeing as it can cost you more later on.
How do interest-only loans function?
The majority of mortgages are either interest or principal loans. You will generally borrow the money and then repay it back, with interest of course. The amount of money borrowed is what you call the principal.
However, if you opt to get an interest-only loan you only have to repay the interest that’s on top and not the money that you borrowed. Eventually the loan will revert back to principal and interest repayments so once that happens, you’ll have to cover the costs for the principal and interest all together.
So essentially interest-only loans will begin with smaller repayments. Yet, over a duration of time as the interest builds up, they’ll end up costing you more and therefore be relatively more expensive in the long run.
Interest-only loans can be quite risky because the principal is the core part of the loan itself. So, if you aren’t necessarily repaying the principal, you don’t really own more of your property. You’re practically borrowing money that you aren’t really paying back to the lender (until of course you start to pay off the principal).
What are the pros and cons of interest-only home loans?
The pros of interest-only loans:
- Smaller repayments. You’ll find that interest-only loans will be cheaper at the start. So, if you’re not in a position to make regular repayments in the beginning, then this loan can be just what you need (at least for the start). However, you’ll eventually be paying more further down the track.
- High-growth investment. In markets that are booming you’ll notice that property investors will opt to use interest-only loans. They’ll purchase the property, make minimal interest-only repayments and watch on as the property increases in value with the booming market. When it’s optimal, they’ll sell the property for a large profit. So essentially, they never would’ve had to repay the loan.
- Savings on tax. If you’re investing, you might find that your repayments can be tax-deductible, especially if you use a 100% offset account. The reason being that any interest on money taken out of an offset account as opposed to redrawing from your home loan are fortunately tax deductible.
Yet the cons of interest-only loans cannot be overlooked:
- No equity. If the value of your property doesn’t increase, you won’t get a whole lot out of it seeing as you aren’t repaying the principal. If you’re not careful, you could end up with negative equity.
- When the loan reverts back to principal and interest, your repayments will increase substantially.
- Larger interest rates. Interest-only loans will generally come with larger interest rates (especially further down the track).
For those who are considered “ahead of the game”, an interest-only loan can be very beneficial. But those who don’t exactly know what they’re doing, things could turn south very quickly if you’re not careful.
The interest-only trap that can catch you out
Pretend you’ve invested in a property back in 2015. Over three years you’ve paid your interest-only repayments. You struggled to find tenants to rent it out, but you patiently waited for its value to increase over time.
Yet, the market actually went south and your property decreased in value. Then you find that your loan has reverted back to principal and interest.
You now have much larger repayments and to top things off, your property isn’t worth a whole lot. None of the principal has been paid and now you want to sell it, but even if you do, you’ll remain in debt.
This is as bad as it can get, and is what we consider to be the trap that can catch you out concerning interest-only loans, especially if you don’t have your wits about you.
Today, is it harder to get an interest-only home loan?
APRA has lifted their limits on interest-only lending, yet your lender will be very cautious when considering to give you a loan as interest-only borrower.
Increase your chances of having your interest-only application approved through:
- Building a large deposit. If you possess a low loan-to-value ratio (LVR), most banks will be more likely to consider your interest-only home loan application. A larger deposit, normally at the very least 20%, will make you application look a whole lot better to the lender.
- Make a plan. Lenders will ask you why you’re looking to get an interest-only home loan instead of a principal and interest loan. So, if you go in unprepared without a plan, that’ll be an immediate red flag for the lender and will potentially dissuade them from granting you their approval. However, if you’re able to illustrate and explain your plan effectively to the lender for an interest-only home loan, you’re much more likely to have your application approved.
- Book in with a mortgage broker. Finding a loan that’ll fit your needs and wants is exactly what a broker will do. Using a broker to evaluate your application before you submit it to the bank is an effective way to maximize the potential of your application and its approval.