Interest only home loans

Standard home loans - where monthly repayments include both the interest and a small proportion of the principal - are still the most common type in Australia. Assuming the borrower adheres to the minimum repayments throughout the life of the loan, they will find themselves debt free at the end of the loan term.

However, in this age of high house prices and rising interest rates, interest only home loans are becoming increasingly popular. Originally designed for those buying an investment property, interest only loans offer most of the same features of standard loans with the added benefit of lower monthly repayments.

For this reason many owner-occupiers, feeling the pinch of higher interest rates, are turning to interest only loans. To be able to minimise monthly repayments or, alternatively, to be able to afford to purchase a more expensive property, is becoming an increasingly attractive proposition. In fact, studies by Cannex have shown that around 1 in every 100 home loans approved to owner-occupiers are currently interest only loans and this figure is steadily rising.

Could an interest only loan work for me?

For many people, interest only loans are an intelligent option, especially in the short term. For disciplined investors with a good head for money and a loan on a house which is not stretching your finances to breaking point, an interest only loan could be viable for you. By investing the money saved into something with a higher return than the interest rate on your home loan, the savvy investor can make their money work for them.

Alternatively, interest only loans can work for people who are building their own home or renovating an existing property. However, if you are planning on using the money saved through having lower monthly repayments to feed your family, run your car, pay your bills or finance any of the other basic essentials of life, an interest only loan is probably not an option you should be considering.

Interest only loans are not considered to be a long-term option. Generally speaking, five to seven years is considered to be the average time spent in one home before selling or refinancing and the interest only loan only needs to cover this period. It is also more useful for larger loan amounts as the savings will be more substantial when compared to a relatively small mortgage.

Main advantages of an interest only loan

Convenience: Since you only have to pay the lower interest only payment, if your budget is tight that month, you will be ok. This also means that you can choose to pay more than you have to, if you have some extra funds in a certain month, which means you can make some dents in paying off the principal debt. Just like a traditional loan, only you have that backup option to pay the smaller interest only payment.

NB: Make sure you will actually have the discipline to make these extra repayments when you have the extra funds available, otherwise there will be no advantage.

Future income increases: If you know your income will rise and you will move to a bigger and better house in the future, instead of starting with the small house and eventually moving to the bigger one, you can skip that step and also skip the costs of moving & repurchasing, by simply buying the bigger house straight away with the lower interest only rate until your income increases.

NB: Make sure that you will be able to bear the cost if the expected income rise does not materialize, and if you would be able to live comfortably making the higher repayments once the interest only term expires.

Case study

Simon has recently purchased land with the intention of building a new home. His bank has approved a home loan of $350,000, which will cover the land purchase, minus 10% deposit, and the total cost charged by Simon's builder.

While his house is being built, Simon is living in a rental property and although his bank is paying his builder in instalments and interest is not charged on his loan until each instalment is remitted, a traditional principal and interest loan would prove to be financially hard for Simon to cover each month. In anticipation of this, Simon arranged for an interest only loan for the first twelve months of the loan term. This way, Simon can afford to pay his rent and keep up the repayments on his home loan until he can move into his new house.

So are interest only loans as good as they sound?

Just because you're not paying any of the principal doesn't mean that you don't have to eventually. Remember, when you get half way through a home loan term and you're still faced with high interest charges plus the full value of the original loan to repay, the interest only loan may not seem quite so attractive.

Interest only loans can also be risky. In times of falling property prices you could be forced to sell your house for a loss if the sale price is less than the principal still owing on the loan. This is known as negative equity.

In the right situation and for the right person interest only loans can be a very useful option. For a low-cost, short term property investment the benefits can easily outweigh the disadvantages. However if an interest only loan is the only way you can afford to get started in your new home, it might be worth reconsidering your options and waiting just a little bit longer.