The repayment of a loan that is made by installments of interest only with the principal

You may be considering an interest-only home loan because of lower initial repayments. Check the pros and cons before going ahead. Make sure you can afford higher repayments at the end of the interest-only period.

If you already have a mortgage and are struggling with your repayments, see problems paying your mortgage for help.

How interest-only home loans work

On an interest-only home loan (mortgage), your repayments only cover interest on the amount borrowed (the principal). For a set period (for example, five years), you pay nothing off the amount borrowed, so it doesn't reduce.

At the end of the interest-only period, the loan will change to a 'principal and interest' loan. You'll start repaying the amount borrowed, as well as interest on that amount. That means higher repayments.

Pros and cons of an interest-only loan

Pros

• Lower repayments during the interest-only period could help you save more or pay off other more expensive debts.
• May be useful for short-term loans, such as bridging finance or a construction loan.
• If you're an investor, you could claim higher tax deductions from an investment property.

Cons

• The interest rate could be higher than on a principal and interest loan. So you pay more over the life of the loan.
• You pay nothing off the principal during the interest-only period, so the amount borrowed doesn't reduce.
• Your repayments will increase after the interest-only period, which may not be affordable.
• If your property doesn't increase in value during the interest-only period, you won't build up any equity. This can put you at risk if there's a market downturn, or your circumstances change and you want to sell.

Calculate your repayments after the interest-only period

Work out how much your repayments will be at the end of the interest-only period. Make sure you can afford the higher repayments.

Give yourself some breathing room. If interest rates rise, your loan repayments could go up even more.

Managing the switch from interest-only to principal and interest

It can be a shock when the interest-only period ends and your repayments go up. Here are some tips to help you manage the switch to principal and interest.

Gradually increase your loan repayments

If your loan lets you make extra repayments, work up to making higher repayments before the switch.

Check when your repayments will go up and by how much. If they will go up by $1,200 a month in a year's time, start paying $100 more each month now.

Get a better deal on your loan

You may be able to get a better interest rate. Use a comparison website to find a lower rate for a similar loan. Then ask your lender (mortgage provider) to match it or offer you a cheaper alternative.

If your lender won't give you a better deal, consider switching home loans. Make sure the benefit is worth the cost.

Talk to your lender

If you're worried you can't afford the new repayments, talk to your lender to discuss your options. You may be able change the terms of your loan, or temporarily pause or reduce your repayments. See problems paying your mortgage.

Get help if you need it

A free, confidential financial counsellor can help you make a plan and negotiate with your lender.

Jasmine considers an interest-only home loan

Jasmine finds an apartment to buy and looks at different loans online. She wants to borrow $500,000, to repay over 25 years.

She considers whether to get a loan with an interest-only period of five years, or a principal and interest loan.

Using the interest-only mortgage calculator, she compares the two. She uses a comparison rate of 4.8%.

The initial monthly repayments on the interest-only loan are $2,010. These increase to $3,250 at the end of the interest-only period.

Jasmine likes the idea of starting with lower repayments. But she realises she won't be able to afford the higher repayments later.

She decides that a principal and interest loan, with constant repayments of $2,875, will work better for her.

Homebuyers feeling blindsided by escalating financing costs might be tempted to explore unconventional home loans known as interest-only mortgages, which have much lower initial payments compared to a standard mortgage.

But these loans have a few major downsides potential borrowers should know about too.

With an interest-only mortgage, you initially only pay the interest on the loan, typically in the first five or 10 years. The advantage is that these initial payments are cheaper since you're not obligated to make payments on the total amount borrowed, known as the principal. 

After the initial interest-only period is over, you start paying the principal and interest for the remainder of the loan term. Payment terms vary, but the interest rate typically resets to whatever the prevailing rate is at the time — which may have gone up. And with the principal now included, these payments can cost you double or triple what you initially paid on the loan, according to the Federal Deposit Insurance Corporation.

If payments become too expensive, borrowers can try to negotiate a longer term or refinance the loan with a cheaper mortgage rate, if it's available. However, refinancing can still cost about 2% to 5% of the total loan, which could offset the savings of a lowered monthly premium.

Right now, interest-only mortgages are "becoming more popular," says Shmuel Shayowitz, president of Approved Funding, a mortgage lending firm. He says that for some homebuyers it "helps bridge the gap with the monthly payment."

But again, as Shayowitz points out, these types of loans have downsides every borrower should consider, even if they can temporarily save you a few hundred bucks a month.

The downsides to interest-only home loans

First off, these loans typically charge higher interest rates than conventional mortgages. The lowered monthly cost only comes from kicking the principal payment down the road to a later date.

And because you are paying a higher interest rate, and making more payments on interest overall, you also will pay more in interest over time, compared to a conventional loan.

Also, there's a risk that mortgage rates could rise over time, as has been the case recently. This would make the monthly payments more expensive than initially expected after the interest-only period ends. The burden of those added costs could put borrowers at risk of defaulting on the loan.

Rate hike increases are usually capped at about 2% after the initial interest-only period expires, but that can still be a significant expense.  

Another risk is that if your home loses value, selling the property later may not cover the total cost of the loan.  

"Think about why you're considering it," says Shayowitz. A bad candidate for an interest-only loan would be someone looking to "shave off a few dollars" of their monthly costs just to get into a home they may not qualify for otherwise.

A good candidate for this type of loan typically has a reliable source of income with enough cash flow to cover mortgage payments after the interest-only period expires. Mortgage rates could still rise, but the buyer would be willing to accept that risk, especially if they plan to sell the home within a few years. Choosing an interest-only mortgage would temporarily free up cash for other expenses or investments.

"So much of this boils down to putting pen to paper," says Andy Darkins, a certified financial planner with wealth management firm Vista Capital Partners. He advises would-be buyers to do a "stress test" of their short- and long-term cash flow before considering an interest-only loan.

"Look at different scenarios," he says. "At the end of the [interest-only] term, what if the payment doubled? And what if it fell somewhere in between that and your initial payments? Ask yourself if you could actually afford the payments in each of those circumstances."

For homeowners looking to minimize monthly costs, another option to consider is a conventional adjustable-rate mortgage, which typically offer lower rates compared to fixed-rate home loans. Again, terms vary, but typically the interest rate for an adjustable mortgage will be locked in for an initial term of five, seven or 10 years, after which it's reset every year, or even every month.

The advantage with an adjustable-rate mortgage is that, unlike interest-only loans, you'd actually start paying off the loan right away, building home equity that you can borrow from later, if needed. And you wouldn't be saddling yourself with thousands of dollars of unnecessary interest charges, either.

Adjustable-rate mortgages still carry some risk, however, as mortgage rates might rise. That's why home purchasers often stick with the cost-certainty offered by fixed-rate mortgages, even though the interest rate for this type of loan tends to be higher.

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