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“There is a risk that they [the RBA] will actually have to lift their policy rate even further.” HSBC Chief Economist Paul Bloxham 26 April, 2024
Given the high interest rate environment we’re all still living in right now, the idea of a home loan repayment that’s substantially lower than what you’re currently paying is attractive. This is always the case with interest-only (IO) loans – because you’re only covering the interest portion of your repayments.
How interest-only home loans work
On an interest-only home loan, your repayments are lower for a set period (eg five years), and you pay nothing off your principal amount borrowed, so your underlying loan doesn't reduce.
Your interest-only loan interest rate tends to be higher than a principal and interest (P&I) loan. After the Great Financial Crisis (GFC), The Australian Prudential & Regulatory Authority (APRA) mandated that interest-only loans carry an interest rate ‘loading.’
For example, as of their current rate card, CBA’s standard variable P&I home loan interest rate is 8.80%. Their IO home loan rate is 9.29%. Both are exclusive of any discounts or special offers.
Isn’t 9.29% ridiculously high for a home loan?
Well, yes – but watch what happens when you apply this to a $600,000 mortgage over 30 years, with a 5 year interest-only period:
P&I repayment = $4,742 per month for the life of the loan.
IO repayment = $4,645 per month for the first 5 years; $5,155 per month for the remaining 25 years (ie when the loan reverts back to a P&I loan).
Remember that the interest rate on the IO loan is higher. If it were the same as the P&I loan (ie 8.80%), the IO repayments would be $4,400 for the first 5 years.
You pay more interest overall with an interest-only loan
This illustrates one of the most obvious downsides to interest-only loans. If you haven’t already checked your maths, here’s where we are:
The total amount of interest paid on the P&I loan over 30 years = $1,106,992.
The total amount of interest paid on the IO loan = $1,225,158.
The difference is almost $120,000 over the 30 year loan.
Important note: these calculations assume the interest rate will not change over the life of the loan. Both the interest rates I used are variable – so they’ll move, and the repayments will shift right along with them. It is uncommon to find interest-only loans offered at fixed rates – but they do exist. A good broker will know which lenders are open to fixed rate interest-only loans.
So, why would anyone take out an interest-only loan?
Seems expensive, right? Well, they’re commonly used by property investors who aren’t looking to hold onto a property for the long-term, and there are benefits to paying in as little as possible in the first few years of your home loan, because this:
Helps your cash flow during large home renovations like a rebuild; bridging finance and construction loans are typically interest-only loans.
Can assist property investors in claiming higher tax deductions from an investment property.
Gives you a year or two of breathing room if you're faced with sudden higher living costs or an income disruption (eg the birth of a child, or you're made redundant).
May help you save more money or pay off other more expensive debts.
Important note: property investors already have to pay a loading if their loan is for an investment property, and not for living in.
Do property investors pay more than one loading for interest-only loans?
The APRA rule about ‘investment loan loading’ is separate from the interest-only loan loading – so a property investor may end up being hit with both. In our example above, the current standard variable interest-only interest rate for property investors is 9.64%.
Based on this, the repayment in our example above for a property investor on an interest-only loan is $4,820 for the first 5 years, and $5,300 for the years afterwards. As property investors tend to buy for capital growth, they’ll likely sell the place in around 5 years to get the capital gain they were aiming for.
Remember that a property investor doesn’t have to get an interest-only loan. This choice is likely based on investment strategies, including any tax adjustments.
Can I get an interest-only mortgage to help me keep up with rising living costs?
That’s certainly an idea that’s been broadcast over social media recently but it should be approached with caution.
An interest-only loan can help you navigate a challenging personal budget crisis in the short-term, but you do eventually have to pay everything back.
In addition, it’s difficult to qualify for an interest-only loan for your own home, because it costs you more in the end. There are fairly strict criteria for interest-only loans on your home (these are less onerous if you’re using an interest-only loan to purchase an investment property). Qualifying for these loans can require you to have:
An acceptable Loan-to-Value Ratio (LVR): most lenders only consider interest-only loans if you’re borrowing 80% or less of your property value.
A strong justification: your broker will need to offer valid reasons for why you’re choosing interest-only repayments over a P&I loan (eg you’re expecting a child and/or a temporary drop in your income).
A strong credit history: a clear history of timely debt and bill payments is essential.
Financial stability: you’ll need to demonstrate that you can afford the higher P&I repayments once your IO term ends – and remember, you’ll have to do this with APRA’s 3% buffer rate on top of your loaded IO interest rate. If you’re purchasing an investment property, the 3% sits on top of your interest-only rate loading plus your investment property loan rate loading as well (are you with me?).
Why is it so tough to get an interest-only home loan for my place?
APRA’s Responsible Lending regulations mean lenders are actively discouraged from offering interest-only loans to homeowners. They’re not allowed to incentivise you in risking your home, and this is a good safeguard to have in place. However, as discussed above, there are some circumstances where choosing an interest-only loan as a homeowner may be valid, including:
Starting a family: transitioning to part-time work due to maternity leave or childcare responsibilities.
Building or renovating: utilising interest-only periods during construction or renovation projects.
Short-term ownership plans: planning to sell your property within a short timeframe.
Property investment: leveraging your home equity for investment purposes (ie to purchase an additional property).
Business cash flow management: addressing fluctuations in your business income, if you’re self-employed.
Personal financial hardship: addressing financial challenges through temporary interest-only repayments.
Debt consolidation: consolidating high-interest debts for short-term relief.
Temporary financial hardship: addressing temporary income disruptions due to illness or injury.
In fact, one of the few times an interest-only loan is offered to a homeowner by a bank, is when you’ve applied to your lender’s Hardship Program. A lot of mortgage holders found themselves applying for hardship help during COVID-19.
All lenders are required to have a Hardship Program. Temporarily allowing you to switch to an interest-only repayment plan is a way to help you through a financial rough patch. These agreements have clear and formalised terms and conditions. Most importantly, they are not supposed to be a long-term solution.
Be aware: The later you resume P&I repayments, the more it costs you in the end.
The risks of interest-only loans
You pay nothing off your principal loan amount during your interest-only period, so the amount you’ve borrowed doesn't reduce. This is why your repayments increase after your interest-only period expires.
Managing your switch from IO to P&I can be a shock. You’ll want to ensure these higher repayments are affordable for you, or you’ll end up worse off.
If your property doesn't increase in value during your 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 – or need – to sell your home quickly. You’re unlikely to make enough from the sale to completely cover your mortgage and other costs.
Navigating your higher repayments after your interest-only period ends
If you're worried you can't afford the new repayments, talk to your lender as early on as possible about your options. You may be able to change the terms of your loan (eg it's possible to extend your interest-only period), or temporarily pause or reduce your repayments (also known as a ‘repayment holiday’).
Again, these are not long-term solutions. You'll need to repay all the 'paused' monies eventually and the longer it takes, the more this costs you.
In conclusion
Interest-only loans definitely have drawbacks, including the potential for increased long-term interest repayments, limited availability of fixed rates, and exposure to market risks. If you’re considering an interest-only loan, carefully weigh your benefits and risks, ensuring they align with your long-term financial goals and circumstances.
Bottom line
Switching to an interest-only home loan for its lower initial repayments can help you through a financial rough patch, but it costs you more over the long-term.
Interest-only loans can prove useful for short-term financing needs like bridging finance or construction loans, and offer potential tax deductions for property investors.
Weigh the pros and cons of getting an interest-only loan carefully, calculating your repayments post the interest-only period to ensure you’re able to meet your new financial obligations, or you could end up in financial straits.
Go deeper:
Why your property valuation matters as much as your home loan interest rate
Can paying $1 extra per day into your mortgage really make a difference to your home loan?
Financial disclaimer
The information contained on this web page is of general nature only and has been prepared without taking into consideration your objectives, needs and financial situation. You should check with a financial professional before making any decisions. Any opinions expressed within an article are those of the author and do not specifically reflect the views of Compare Club Australia Pty Ltd.
