Considering an interest-only home loan? What you need to know

An interest-only home loan, as the name suggests, is where you only pay the interest on a loan and not the principal (the original amount you borrowed).

While authorities such as the Reserve Bank often see them as risky, interest-only loans can be helpful in some circumstances.

If you’re considering an interest-only loan, here’s what you need to know.

How long do they go for?
These loans are typically last for five years at most, before reverting back to principal and interest (where you have to pay back, through regular payments, both interest and the initial sum you borrowed).

You could potentially apply for another interest-only loan after your first one winds up, perhaps by refinancing (where you take a new mortgage to repay an existing loan). But you might not get it – and you’d still have to pay off the principal eventually.

What are the upsides of an interest-only loan?
An interest-only loan means you’ll have more cash available to cover other costs, or invest elsewhere.

You can use a mortgage calculator to work out how much extra cash you’d have if you switched from a principal and interest loan to an interest-only loan. It’s typically hundreds of dollars per week.

This may get you a bit more wriggle room for daily expenses. Or, some people use the extra cash to invest in other things – such as shares – in the hope they can make more money overall and pick up some tax benefits along the way. That’s why interest-only loans are often popular among investors. Of course, this strategy comes with risk.

An interest-only loan may also have a redraw facility, allowing you to add extra payments into the loan (above and beyond the interest) if you want, and withdraw money later when you need cash. This can allow people to avoid a personal loan, which usually has a much higher interest rate.

Regular principal and interest loans may also have a redraw facility but the regular payments of principal are unavailable for redraw. That means less flexibility for the borrower.

What are the downsides?
The interest rates on interest-only loans are generally higher than principal and interest loans.

For example, the RBA July 2022 indicator rate for owner-occupier interest-only rates is 6.31%.

But the equivalent variable rate for principal and interest loans is 5.77% (the indicator rate is just a guide; the actual difference varies from bank to bank).

Interest-only loans can cost you a lot more over time than a regular principal and interest loan.

This means a borrower needs to manage their finances well to ensure they can cover the interest payments now and still have enough to pay down the principal eventually. So you’ll need a plan for how you’re going to do that when the interest-only loan ends.

There is also a risk of a shock – such as job loss, personal crisis or housing crash – causing the borrower to default on the loan altogether.

If the borrower defaults on an interest-only loan, they may lose the house and the bank is left with a debt that was not substantially repaid (because the borrower had not yet made a dent in the principal). It’s a lose-lose situation.

Are interest-only loans common?
Interest-only loans represent 11.3% of all home loans in Australia.

This figure has been trending down over the past five years, due in part to tighter lending restrictions and the fact low interest rates have made principal and interest loans relatively cheap recently.

What does the research say?
One Dutch study found “households that are more risk-averse and less literate are significantly less likely to choose an interest-only mortgage”. This partly due to lower initial repayments and wealthy households preferring the financial flexibility.

Interest-only borrowing has also been found to fuel housing speculation and reduce housing affordability.

A US study found borrowers also tend to default more.

A Danish study found that once the interest-only lower repayment period is over and the loan reverts to principal and interest, those who didn’t make principal repayments suffered a large drop in disposable income.

Financial flexibility comes with a catch
With rates rising, interest-only loans may sound like an appealing way to have more cash available to cover other costs in life.

But just remember financial flexibility comes with a catch. An interest-only loan could be more expensive in the long run.

For some people, that cost will be worth it if it allows them to hold onto the house during a brief tough period or make more money investing elsewhere. But it’s a risk.

And when the interest-only loan ends, you’re still stuck with the task of paying off the money you borrowed from the bank in the first place (with interest).

Originally published by The Conversation
Author: Adrian Lee, Associate Professor in Property and Real Estate, Deakin University