What is an interest only mortgage?
Your home loan has two parts: the principal, which is the amount you originally borrowed, and the interest, which is the cost of borrowing that money.
With an interest-only home loan, you pay only the interest on your loan for a set period (usually a few years), without repaying any of the principal. This means your monthly payments are lower compared to a principal-and-interest loan.
Pros and cons of an interest only loan.
Interest only loans can be a great tool for investors, but like any financial product, they come with both advantages and drawbacks. Here’s a quick look at the main pros and cons to help you decide if this option suits your investment goals.
Interest only loan benefits.
Boost your cash flow.
One of the key advantages of an interest only loan for an investment property is that it can ease the pressure on your monthly budget by lowering your repayments and freeing up cash to use elsewhere – like saving for a deposit on that fixer-upper you’ve been eyeing or covering other expenses.
Tax perks.
The interest portion of your repayments can often be offset against rental income and other property costs, which can reduce your taxable income. Plus, if you have a fixed rate loan and pay interest upfront, you might be able to claim a tax break for up to 12 months of prepaid interest. More interest paid equals higher tax deductions. Nice one!
Benefit from capital growth.
While you’re keeping repayments low, your property can still increase in value over time, helping to build your wealth.
Flexible equity building.
Some loans offer an offset account linked to your mortgage, where extra payments can build a buffer similar to equity. You could choose to redraw this money later for more investments, giving you flexibility.
Drawbacks of interest only loans.
Higher interest.
Lower monthly repayments can make an investment property seem more affordable. But while you’re not paying off the principal, the amount of interest you’re up for will always be higher.
The Australian Securities and Investments Commission (ASIC) has broken down this cost over time. For example, they found that on a $500,000 loan with a rate of 6%, a borrower making principal plus interest repayments would pay total interest costs of $579,032 over a 30-year term. By contrast, if a borrower opted to make interest-only payments for five years out of the same 30-year loan, the long-term interest bill would rise to $616,258 – that’s $37,226 more than the alternative.
You’re not building equity.
While you’re making payments on an interest only loan, you’re not reducing any of the principal. At the end of the loan term, you still owe the full balance of the mortgage.
Depending on how the market is performing, this could significantly impact your overall financial position as your property may be worth a lot more than what you paid for it – or a lot less. If the capital growth doesn’t cover the cost of selling, you could be facing a net loss.
Big payment jump.
Most loans have an interest only period. Once that ends, you start repaying both principal and interest, which means your monthly repayments will increase – sometimes quite a lot. This can be a shock to your budget if you’re not prepared.
Requires careful planning.
If you’re planning to hold your property for a short time (like flipping within five years), interest only can work well. But if you plan to keep it longer, you need to figure out whether you can afford the higher repayments later or have other ways to build equity.
Understand the true cost of interest only loans
It's a good rule of thumb to work out what the cost of your repayments will be at the end of the interest only period and to make sure you can afford to make the higher repayments.
Use our Interest Only Home Loan Calculator to make the best decision for your financial situation.
Choosing home loans with interest only payments could help you get your foot in the door sooner, but before you sign, speak to your lender about interest only investment loan rates and how much it will really cost you over time.
Want to know more about interest only loans?
Both ME’s Basic and Flexible Home Loans are available as interest only options. Contact a ME Mobile Banker to get advice on what’s right for you.
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This article is prepared based on general information. It does not take into account individual financial objectives or needs and is not financial product advice.