An interest-only loan allows you to repay only the monthly interest charged on the total amount borrowed from the bank for a set period. There are pros and cons of going for an interest-only loan, which we are yet to explain in the article.
But before diving into it, it’s important to understand that a home loan is made up of two parts:
- The principal – total amount borrowed
- The interest – a percentage of the total amount borrowed that will be charged on your loan.
When you buy a house using a mortgage, some banks will give you repayment options that include paying the principal and interest simultaneously or only paying the interest part of the loan for a set period, usually up to five years. This is what we call Interest-only repayments.
At the end of this agreed period, your loan will change to a ‘Principal and Interest’, which means you will only then start repaying the amount borrowed, plus the interest on that.
Both options have their pros and cons, but the choice will depend on your situation and goals.
Before deciding which one to go for, we recommend you organize your financial life, understand how each option works and talk to your mortgage broker to learn more about your possibilities. We would be more than happy if you chose Capta Financial to guide you in this journey.
Pros of Interest Only repayments
Repayments are lower during the interest-only period
On an interest-only period, you won’t be paying the principal at all, which means your monthly repayment will be much lower for the first 1 to 5 years (depending on your interest-only agreed time).
This is a very positive aspect for those facing a temporary income reduction, for example, or are looking to reduce their expenses to find a more balanced financial life. It makes it easier to budget and plan how much you will pay each month.
As long as you are organized, the interest-only could help you save more or pay off other debts while living in the house and before you are ready to start repaying the principal.
For those buying an investment property, having a higher cash flow is also a good strategy to invest the money in renovations, making it more appealing to potential tenants.
Tax benefits are more attractive for investors
If you are buying an investment property, taxes are usually more attractive on the interest-only repayment, so that it might work as a financial strategy for investors as well.
Cons of Interest Only repayments
The principal amount will not be reduced during the set period
With the interest-only, you will not be paying any debt at all: if you borrow $450,000 and decide to go for an interest-only loan for 5 years, for example, after those five years of making repayments, you will still own the same $450,000.
It might sound like it doesn’t make any sense for you to make repayments on a debt that remains the same for years, but in some specific cases – as mentioned above – it may be beneficial.
You may pay more interest in the long run
The amount of interest paid in the long run is usually higher than choosing the principal and interest repayment for the whole time. This happens because the interest rate is calculated based on the outstanding balance of your home loan.
The more you own on your home loan, the higher will be the interest charged. This means that for the whole interest-only period, your outstanding balance remains at 100%, so that the interest rate will be the highest.
Once you start paying off the principal, the interest rate will reduce according to the amount owed.
Who can apply for an interest-only home loan?
Although anyone can apply for it, an interest home loan might not be the smartest choice for everyone, simply because you will be making monthly repayments but not really owning any percentage of the house yet.
However, there are some specific cases in which we may recommend choosing an interest-only home loan as a strategy. For example:
- If you are an investor buying a property to make some renovations and sell it within a short time, the extra money, in the beginning, might be helpful;
- If you are planning to renovate the house you are buying before living in there but still need to pay rent or mortgage from another property, budgeting the first repayment months are certainly a good strategy;
- If you or your partner are on parental leave, for example, and are expecting a period of regular income, having a place to call home and saving on repayments for a while can help a lot;
- If you have part of your income compromised with an unusual expense, such as paying for your studies, for example, the interest-only home loan might be beneficial too.
Please note that these are just some examples, and we still recommend you to talk to a mortgage broker. Please get in touch with us to understand whether an interest-only loan might suit your needs, and we will be happy to guide you on this journey.