By Ryan Ewart, Mortgage Choice servicing the NSW Northern Beaches
Content reviewed and updated April, 2014
Taking an interest in interest-only loans
Interest-only loans are a type of home loan that allows you to repay just the interest on the principal loan amount over the life of the loan. No principal repayments are required during the loan term.
They're a popular loan of choice among all kinds of borrowers. Why? Repayments are lower than what you would pay on a principal and interest (‘P & I') loan. You can redirect the extra money you would normally put towards paying off the principal into other areas such as home improvements.
What's a typical loan term for an interest-only loan?
One to five years is a typical loan term for an interest-only loan. At the end of the interest-only period, you must start making principal and interest repayments.
I generally advise customers to ensure they are prepared for their repayments to rise sharply at the end of the interest-only loan term. Lenders assess your ability to repay the interest-only loan on the basis of it being a principal and interest loan, so the shift to principal and interest should be manageable.
Interest-only: a popular option for investors
Interest-only loans are extremely popular among investors. Investors' interest payments are tax deductible; they can make minimal loan repayments during the loan term and re-sell the property when it appreciates significantly in value.
The pros and cons of interest-only
There are some potential drawbacks to interest-only loans, particularly for people lacking financial discipline. If you're satisfied with your principal balance staying the same, by all means pay the minimum interest-only loan amount.
I tend to suggest to customers wanting to reduce the principal balance to set up a direct debit for an extra $200-300 a month to be paid into the home loan. Every dollar you pay over and above the interest only repayment will reduce the principal of the loan, therefore making it principal and interest. The extra repayments can be redrawn as needed and in times of emergency. But again, financial discipline is key to reducing the principal amount.