Interest only home loans are not your typical mortgage, and are by no means the best choice for many home buyers. Canstar investigates interest only loans and their pros and cons.
What is an interest only home loan?
An interest only loan requires borrowers to pay only interest charges on the loan, and not any money towards reducing the actual loan sum (the loan principal). This is different to a principal and interest (P&I) home loan, when repayments reduce the principal loan sum, as well as covering interest charges.
Anybody can apply for an interest only home loan, but they are not widely advertised by banks and are primarily used by property investors who plan to make short-term capitals gains on a property.
Pros of interest only home loans
1) Good for property investors
In a rising market, if you’re planning to make short-term capital gains by buying and selling property, interest only home loans require less capital investment in the form of mortgage repayments. This was especially relevant prior to March 2021, when property investors were able to claim tax deductions on their interest payments.
Although the bright-line property rule and the removal of tax deductibility on interest payments have made property investment less rewarding in the short-term, interest only loans are still useful for those seeking to make money from housing. For example, an investor could use an interest only loan to buy a holiday home in order to profit from short-term rentals.
2) Cheaper repayments
Because you’re only paying off the interest on the loan, your repayments will be smaller than if you were paying off interest plus money towards reducing the loan principal. This can leave you more money in your pocket each month, which you could put to another use, for example, other investments.
Interest only loans are also an option if you know that your income will rise in the near future and want to manage your cashflow with smaller monthly repayments until your income increases. For example, to cover a period of unpaid leave, or if you are between jobs.
3) More flexibility
Interest only loans usually have more flexible repayment terms than fixed-term home loans, meaning you are free to make lump-sum repayments, or pay off the loan, at any time without being penalised.
Cons of interest only home loans
While interest only mortgages can be a useful financial tool in some circumstances, as with all financial products, there are risks involved. Some of the downsides of interest only home loans, include:
1) Negative equity
Interest only mortgages, when used as a property investment tool, only make positive returns in a rising property market. When it comes time to sell a property bought with an interest only mortgage, you must repay the full loan amount. If the price of the property falls – leaving you with negative equity – and sells for less than the loan amount, you will need to cover the difference.
2) Higher interest rates
Interest only mortgages usually come with much higher interest rates than regular P&I home loans. Not only are they usually variable rate mortgages, which come with higher rates, because they are the realm of property investors, they attract an added interest premium.
Here are the current rates for owner-occupiers and investors on Canstar’s database. As you can see, average investor floating rates are the highest of the bunch:
Average Mortgage Rates (as of 09/06/23)
|Floating||1-Year Fixed||2-Year Fixed||3-Year Fixed||4-Year Fixed||5-Year Fixed|
3) Limited availability
Interest only mortgages are very much a niche product. Not all mortgage lenders offer them and there is less choice in the market, meaning securing one to fit your home-ownership requirements is likely to be much harder than finding a similar P&I home loan.
Is an interest only home loan right for me?
Interest only home loans can be a helpful financial tool, and can be ideal for:
- Property investors banking on making short-term capital gains
- Investing using less capital
- Home owners looking to make short-term changes to their cash flow by reducing mortgage repayment costs
However, interest only loans are not ideal for long-term owner-occupiers due to their associated higher interest costs.
Overall, each person’s financial situation is unique, so make sure you do your research, seek professional advice, and carefully weigh up the pros and cons of an interest only home loan to see if it’s suited to your personal finances.
About the author of this page
This report was written by Canstar Content Producer, Caitlin Bingham. Caitlin is an experienced writer whose passion for creativity led her to study communication and journalism. She began her career freelancing as a Search Engine Optimiser, before joining the Canstar team.
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