An interest-only home loan can provide short-term relief by lowering your repayments, freeing up funds for other expenses. While this can be appealing, it comes with trade-offs.
Whether you’re an owner-occupier or a property investor, understanding how interest-only loans work, along with their benefits and risks, can help you decide if it’s the right option for you.
What is an interest-only home loan?
An interest-only home loan lets you make repayments that cover only the interest charged on your loan for a set period, not the loan amount itself. This differs from a standard principal-and-interest home loan where each repayment goes toward both the principal (the amount you borrowed) and the interest charged on it.
During the interest-only period, your repayments are lower, but your loan balance doesn’t decrease. Once the period ends, you’ll still owe the full principal plus accrued interest on that amount – meaning you’ll pay more in total interest over the life of the loan.
For example, if you took out a 5-year interest-only term on a 25-year, $500,000 loan with a 6% p.a. interest rate, your monthly repayment during this time would be around $2,500. Over five years, you’d pay $150,000 in interest, but none of your principal – meaning at the end of the five years, you would still owe the full $500,000. After switching to principal and interest repayments for the remaining 20 years of the loan, your monthly repayments would increase to around $3,600, since you would now need to pay off both the $500,000 principal and ongoing interest on this amount.
How long an interest-only period can I have?
Interest-only periods usually last one to five years for owner-occupier home loans, and up to ten or even 15 years for investment loans. After this period ends, your loan will typically either:
- Switch automatically to a principal-and-interest loan.
- Require you to reapply if you want to extend the interest-only period – but most lenders are only willing to do this once, if at all.
Interest-only periods aren’t offered for longer terms because they increase financial risk for both lenders and borrowers. Since the principal isn’t being repaid, repayments rise significantly once the period ends, making it more challenging to manage the loan if you’re unprepared.
Are interest-only rates fixed or variable?
Interest-only home loans can have fixed or variable interest rates, just like standard home loans.
- Fixed interest rate: your rate and monthly repayments on your mortgage stay the same for an agreed period, providing protection from interest rate rises. However, you won’t benefit if rates fall.
- Variable interest rate: your rate moves up or down with market changes, so your repayments may increase or decrease over time. However, variable home loans usually offer more flexibility, such as the ability to make extra repayments or access redraw facilities.
Whether fixed or variable, interest-only rates are typically higher than principal-and-interest rates because they are considered riskier for lenders. With interest-only repayments, the loan balance doesn’t reduce during the interest-only period, meaning the lender’s exposure remains higher, and borrowers face a bigger jump in repayments when the period ends.
What are the costs of an interest-only home loan?
Interest-only home loans generally cost more than standard principal-and-interest loans. This is due to:
- Higher interest rates: the increased risk during the interest-free period means interest rates are higher.
- Delayed principal repayments: your loan balance doesn’t reduce during the interest-only period, meaning you pay more interest over the life of the loan.
- Higher repayments later: once the interest-only period ends, monthly repayments increase to start repaying the principal.
Let’s look at a basic example of a $700,000 mortgage over 30 years with a fixed 7% interest rate. The first scenario assumes a three-year interest-only period, followed by principal-and-interest repayments for the remaining 27 years. The second scenario shows principal-and-interest repayments for the full 30 years.
| Scenario | Period | Monthly repayment | Total cost |
|---|---|---|---|
| Scenario 1: Interest-only | 3 years (interest-only) | $4,083 | |
| 27 years (principal and interest) | $4,815 | $1,706,964 | |
| Scenario 2: Principal and interest | 30 years | $4,657 | $1,676,562 |
| Cost difference | $30,402 | ||
| This is a simplified example for illustration only. It assumes a fixed interest rate for the full 30-year loan and does not include fees, charges or other costs. | |||
As this example shows, interest-only repayments mean lower monthly payments initially, which can help with short-term cash flow. However, once the interest-only period ends, repayments increase significantly to cover both principal and interest. Over the life of the loan, the total cost is higher – in this case, $30,402 more than a standard principal-and-interest loan.
Interest-only mortgage: investor vs owner-occupier
You can take out an interest-only loan as either an investor or an owner-occupier, but there will be different motivations for doing so as well as different terms.
Investor
Interest-only home loans are popular with property investors because interest payments are often tax-deductible and lower repayments in the short term can improve cash flow, freeing up funds for other investments or expenses. Investors may also benefit from capital growth, as the property can increase in value while repayments remain low.
Investor interest-only loans often run up to ten, and occasionally even 15, years, giving more flexibility for longer-term strategies.
Owner-occupier
As an owner-occupier, interest-only loans can be useful if you need to free up extra cash in the short term, since your repayments are lower and none goes toward the principal. This can help cover costs like home improvements and repairs or act as a financial buffer if money is tight.
Compared with investment loans, owner-occupier interest-only periods are typically shorter, capped at five years.
Whether you’re an investor or owner-occupier, it’s important to remember that once the interest-only period ends, repayments increase and you’ll pay more interest over the life of the loan than if you had been making principal-and-interest repayments from the start.
Why apply for a home loan with Savvy
How to apply for an interest-only home loan
There are two ways to take out an interest-only home loan:
- When applying for a new loan: when submitting your loan application, you’ll have the option to select an interest-only period.
- During your existing loan term: if you already have a home loan, you can contact your lender to discuss switching to interest-only repayments. Note that lenders typically don’t allow this change in the final five years of your loan term.
When applying for a new loan, the approval process is the same as a standard home loan. You’ll need to provide details of your income, expenses, assets and liabilities, and your lender will carry out a credit check.
However, lenders are often more cautious with interest-only loans because there’s a greater risk of default. As well as paying a higher interest rate, you’ll also need to show that you can manage the higher repayments once the interest-only period ends.
To improve your chances of approval:
- Put down a larger deposit: this lowers your loan-to-value ratio (LVR), making your loan less risky in the eyes of lenders.
- Explain your reasons: be clear about why you want an interest-only loan, such as managing cash flow during renovations or supporting an investment strategy.
- Use a mortgage broker: a broker can compare lenders and help you present a strong application. If you need help, Savvy’s mortgage broking team can help you find suitable options and guide you through the process.
Interest-only home loan pros and cons
Pros
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Improved cash flow
lower repayments during the interest-only period can free up money for other purposes.
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Tax advantages for investors
Investors may be able to claim interest payments as a tax deduction, reducing taxable income.
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Extra repayments
You can often make extra repayments without penalty, helping you reduce your balance faster.
Cons
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Higher long-term cost
Because you’re not reducing the principal during the interest-only period, you’ll pay more interest over the life of the loan.
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Payments can increase
Once principal repayments begin, your minimum repayments can rise significantly.
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Slower equity growth
Since the loan balance doesn’t reduce, your equity builds only through property value increases, which can limit refinancing or selling options.
How do I know if an interest-only home loan is right for me?
Interest-only home loans can end up costing more over time, so for most people, a principal-and-interest loan makes more sense. However, there are some situations where an interest-only loan can be a convenient short-term option:
Investment loans
A lot of interest-only loans are aimed at property investors. Lower repayments in the short term can free up cash for other investments or expenses, and the interest is often tax-deductible. In addition, your property could still grow in value while your repayments stay lower.
Bridging loans
If you’re selling one home and buying another, you might find yourself having to juggle two mortgages. A bridging loan is a short-term loan that covers funding gaps while waiting for your old property to sell, usually allowing you to pay just the interest. These loans usually last up to 12 months and then switch to principal-and-interest once one property is sold.
Construction loans
Construction loans are usually interest-only while your build or renovation is underway, which helps keep repayments lower while work is happening. Once construction is complete, the loan reverts to principal-and-interest, so your repayments increase to start paying down the principal.
Short-term changes to income or circumstances
Some lenders let you switch to an interest-only loan if your income drops or your situation changes – for example, taking parental leave or dealing with health issues. It can also be useful if you need to free up funds for other short-term priorities, such as home improvements, repairs or managing other financial commitments.
