What is an Interest Only Home Loan? Are they Worth it in 2024?

What is an interest only home loan?

An interest only home loan requires a borrower to pay only the interest costs and fees for the home loan as opposed to also paying down the principal, during the agreed interest only period. It is a repayment strategy that can be employed for a limited time, often one to five years, within a standard 30 year overall loan term.

During an interest only repayment period the outstanding principal loan balance will not decrease. After an initial interest only period, most loans will revert to principal and interest repayments over the remaining term of the loan.

Interest only vs Principal and interest?

Interest only and principal and interest are the two most common repayment options for home loans.

Interest only (IO) home loans are usually for a set period (often one to five years) during which repayments are designed to initially cover costs and fees only, without reducing the principal loan amount owed to the lender.

Principal and interest (P&I) repayments are designed to reduce the loan amount to zero over the term of the loan.

Below is a comparison of two loans on the same interest rate over 30yrs. One has opted for the initial 5yrs to be an interest only home loan, the other pays principal and interest from the start.

Let’s break down the differences between the two options and their impact.

Monthly impact during the interest only period

A standard repayment of principal and interest is $3,221 with the first month minimum repayment made up of interest ($2,500) and Principal ($721).

During an interest only period the borrower only needs to only pay the interest component. This results in a lower monthly payment at $2,500 per month for the first five years. This is because the borrower is not paying and Principal (the “P” in P&I).

When the interest only period ends

After the interest only period the borrower is required to pay down the loan with principal and interest repayments over the remaining 25yrs. Our table shows these repayments will be higher than if the borrower elected to pay principal and interest from the start.

If the borrower did elect for the first five years to be interest only the monthly repayment would change from $2,500 to $3,508 when principal and interest payments begin—instead of the $3,221 it could have been if the borrower were to make these payments from the start.

Why? Because the borrower has left themselves with 25 years to pay off the loan instead of 30 years.

Overall loan cost

Assuming you stick to minimum monthly repayments throughout the loan term, an interest only home loan will cost more in interest than a standard home loan with principal and interest repayments. One major reason for this is that interest is calculated daily, based on the principal you owe. So, the longer you take to reduce your loan the more interest owed—even if interest rates are the same for principal and interest vs interest only.

Using our example comparison, the figure below depicts over $42,000 of extra interest could be payable over the life of the loan. And this assumes rates for the two repayment options are the same whereas in practise there is often a higher rate attributed to an interest only home loan.

Why are interest only rates often higher?

When considering the two main repayment options for the same home loan product, the interest only home loan will often attract a higher interest rate.

Why? The answer is to do with risk. Lenders need most borrowers to be paying down their loans, otherwise lenders (and borrowers) become over-exposed to fluctuations in property values. This brings into play a higher chance of a borrower being in negative equity—where property value drops and the borrower owes more than a property is worth.

Lenders in Australia used to offer the same product interest rate regardless of your repayment preference—interest only vs principal and interest. However, in 2014 the banking regulator APRA, noticed too many interest-only and investment home loans being advanced to borrowers. They required lenders to implement changes to encouraged borrowers pay down principal, come up with bigger deposits and take less risk with property investment loans. One tool used to drive borrower behaviour is, you guessed it—interest rates.

Given there is often a premium rate paid for interest only home loans a borrower should make sure they understand any justification for going down the interest only road.

Are interest only home loans worth it?

Given interest only home loans in Australia attract an interest premium compared to principal and interest repayment options, and these loans could cost more over the loan term—are they still worth it? Do they have a place?

The answer is a resounding—Yes.

They have always had a place. The reason the regulator stepped in was because they were being over-used. They are not, for example, for a first time buyer with a small deposit who is attracted to an interest only home loan because the repayments “seem cheaper” than the principal and interest alternative—when in fact the it could prove more costly.

There are many reasons for taking out an interest only home loan. These will be specific to each borrower and align with their goals and objectives. This will involve a thorough needs analysis and assessment by a lender or mortgage broker.

I introduce borrowers to licensed mortgage brokers.

Here are some situations where an interest only home loan might be considered as a preferred repayment method.

Investment strategy

It is widely known that loans expenses (like the interest cost) associated with investments—like buying shares or investment property—might be eligible to claim as a tax-deductible expense. This could see some borrowers able to reduce their taxable income. For specific detail around the area of negative gearing associated with an investment loan strategy I recommend borrowers seek tax advice.

An investment property loan with low monthly repayments keeps expenses low which sometimes enables investors to generate more cash flow.

The borrower always needs to consider their investment strategy for navigating the higher repayments that will eventually fall due after the interest only period finishes.

Given the interest can be a tax-deductible expense for investment loans, investors often see no need to pay principal as well. Many investors prefer to reallocate this principal elsewhere—like paying down extra off their owner-occupied home loan.

Investors are often incentivised to pay down any owner-occupied debt when compared to investment debt that can be negatively geared.

Owner-Occupiers

Interest rates are often significantly higher on owner-occupied home loans with interest only payments compared to principal and interest repayments. This one of many factors to considered before opting for an interest only home loan.

Interest only repayments are considered by borrowers who need to cut back on their expenses for a while. It is usually an interim measure since the borrowers would have demonstrated the capacity to repay the home loan when they took out the loan.

Examples of when this is considered could be a temporary reduction in income due to further education or maternity leave. Given the eventual effect in increasing the overall loan cost and eventual principal and interest repayments this option requires careful consideration.

Some owner-occupiers might consider keeping their loan in place rather than paying it off. There are tax reasons for doing this provided the borrower is entertaining the idea of renting out their property in the future.

Pros and cons of interest only home loans

Given the differences between interest only vs principal and interest repayments, a borrower needs review both repayment options as part of any comparison process—which a mortgage broker is well equipped to assist with. Below I highlight some pros and cons to consider.

Pros

• Initial lower monthly repayments make it easier to hold an investment property
• Interest only payments leave more available cash for other priorities.
• Many loans still enable the use of offset accounts or redraw. This means a borrower could reduce their interest payments if the product considers loan overpayments or offset account balances in their interest calculations.

Cons

• Often higher interest rates for interest only payments than the principal and interest alternative for the same product. Therefore, the actual cost of the loan can be more even though it might not feel that way with lower monthly loan payments.
• Higher cost to the loan over the life of the loan compared to starting out on principal and interest repayments.
• When the loan reverts from interest only to principal and interest the repayments could be significantly higher than if the borrower opted for principal and interest from the outset.
• The borrower is not building up any equity through repayments. They are relying on the property increasing in value. This introduces more chance of being in a negative equity position.
• Just because a spreadsheet says interest only is the right strategy— because it will leave you with spare money in your hand each month—it is still up to you to follow through on the strategy. The risk is that you spend your ‘spare’ money on nice things rather than the priorities you had at the outset.

Lender considerations for interest only home loans

A successful application for an interest only repayment strategy needs to demonstrate how it is suitable for the borrower. In addition to this, I have highlighted some (not all) key criteria lenders will look to as part of any assessment.

Loan to value ratio

Interest only home loans usually require a larger deposit to minimise the chances of negative equity to the borrower and lender alike. So, the lower your deposit the more chance the lender will prefer principal interest payments to improve the risk position for you—and them.

Lender appetite

Not all lenders are competing for interest only business. Some have more of an appetite than others. Significant home loan research needs to be done when assessing options for interest only home loans and this is typically when a mortgage broker is engaged.

Investors vs owner-occupiers

Home loan purpose goes a long way to determining an interest only rates. It is more commonly accepted for investors to have an interest only home loan strategy. Many investment strategies are built around this type of repayment and lenders understand this. Lenders are less inclined to want to attract owner-occupiers wanting interest only home loans vs principal and interest—something interest rates for the owner-occupied option often reflect.

Repayment capacity

Lenders will continue to assess residential mortgage applications based on capacity to repay. There are several assessment hurdles to overcome on the way to a loan approval. Interest only home loans are no different and usually require a stronger asset and disposable income position than an application requesting principal and interest repayments.

Prepare your repayment plan

While it is easy to get used to lower interest only repayments, borrowers need to remember their loan will likely revert to higher principal and interest repayments after the interest only period ends. This enables the loan to be paid down over the loan term remaining.

There are situations where borrowers get to the end of an interest only period and wish for it to continue rather than revert to higher principal and interest repayments. Provided this repayment type continues to suit the borrowers needs then some lenders will allow for an extension of an interest only period. These requests will often require a level of re-assessment by the lender or even a refinance to another lender.

Some investors might look to generate an income—say rent from an investment property—and as such might prefer interest only repayments for as long as possible. Quite often their exit strategy will be to sell their property at a point in the future which often sees the investment loan paid down.

No matter your strategy, interest only homes loans require preparation so there are no nasty surprises when it comes time to make higher repayments.

Final word

Interest only home loans can be worth it. There are many reasons for borrowers to consider them. Borrowers need to weigh up the pros and cons and decide whether this repayment option is suited to their situation.

Most importantly, while payments are comparatively low during any interest only period, borrowers need to be aware these loans are not designed to be interest only forever and they need a plan to pay the loan down eventually.