Time to read : 4 Minutes
10-year interest-only home loans with no reassessment at the half-way point are a hot topic in lending right now. After all, not having to repay your mortgage for a whole decade sounds great, right?!
But, as is often the case with money, what seems too good to be true usually is.
And this is why it’s important to understand all the possible implications before locking yourself into a loan, especially a 10-year interest-only home loan.
Let’s take a closer look at how this type of loan works and what it could mean for your finances.
What is an interest-only loan?
In simple terms, an interest-only loan means you just pay the interest over a fixed period of time. And what that boils down to, is you’re delaying paying off your actual debt (the principal amount borrowed).
Interest-only loans are more commonly used by investors. Some lenders like AMP recently launched 10-year interest-only home loans without the usual requirement of a reassessment after five years.
Be aware: interest-only should not be confused with interest-free. Interest-only means your repayments are just covering the interest, not the amount borrowed. Interest-free is the opposite – repayments cover the debt and no interest is applied. But interest-free home loans with a bank don’t exist.
What are the benefits of an interest-only loan?
The most obvious benefit of an interest-only loan is that it reduces the size of your loan repayments.
This can work in your favour when cash flow is important to you – such as maximising money available for high-growth investments or for self-employed people to reinvest in their business.
Property investors, especially those using negative gearing, also like interest-only loans because investment interest is tax deductible – more interest paid means greater tax offsets. To find out more about this, talk to a financial professional.
💡Did you know you can temporarily move to interest-only to reduce your repayments during financial hardship? It may help you avoid defaulting on your loan and losing your home.
Why interest-only costs more over time
An interest-only loan means you still owe the full amount you borrow once your interest-only period ends. And, because you don’t make any repayments on the borrowed amount, the interest you pay doesn’t go down.
Here’s an example.
Let’s say you borrow $1 million and take out a 10-year interest-only loan with a 6% interest rate. Your monthly repayments would be $5,000. At the end of the 10 years, you would have paid $600,000 in interest but still owe the original $1 million borrowed.
Compare this with a principal and interest loan, under the same conditions. Monthly repayments would be higher at roughly $5,996. But, because you’re gradually paying off the principal amount ($1 million), the amount of interest you accrue becomes less over time. By the end of the 10 years, you will have paid $163,224 in interest and owe $835,600.
Now let’s say your goal was to pay off the entire $1 million in 10 years. You would need to pay $11,102 per month with $332,246 paid in interest. This would be a bit more than half the amount of the interest-only option (see above), but you’re now debt-free.
What are other drawbacks of interest-only loans?
Besides the overall cost, interest-only loans generally have some other trade-offs:
Often come with higher interest rates than principal and interest loans.
Repayments rise a lot once the interest-only period expires, which may be unaffordable (especially if your circumstances have changed or your income is reduced in that time).
You may be locked in for the full interest-only period, making it difficult to refinance or sell should you change your mind in the future without facing hefty financial penalties.
It could limit your future equity. Because your debt remains the same, the only equity you have is if the property’s value goes up. If the market goes down from what you paid, you go into negative equity (owing more than the property is worth).
Be aware: AMP (and possibly other lenders) have said it will offer 10-year interest-only loans to retirees. While everyone’s situation is different, it’s generally not a good idea to carry debts into retirement because your super will ultimately foot the bill. That could mean less money in your nest egg to cover living costs and healthcare.
Bottom line
Interest-only loans may be tempting, but they’re not for everyone. A 10-year interest-only period can carry massive financial costs plus risks.
Here’s a checklist before signing up for this type of loan:
Make sure you have your finances in order. Here’s a piece I wrote on how to build foundations for financial security.
Understand the true costs you could face. The best way to do this is to run through the numbers for different scenarios, like in the examples above.
Have a plan for maximising the money ‘saved’ in making lower repayments, for example, will you invest it?
Put together an exit strategy. This needs to outline what you’ll do once the 10-year term is finished or how you’ll manage any penalties for not sticking to the 10-year term.
There’s a lot to consider so if you need help with this checklist, it’s a good idea to talk to a professional for advice on your unique circumstances. Speak to your lender, accountant or financial adviser first.
Go deeper:
5 important foundations to help you build financial security
Why the structure of your investment property loan can make or break your success
Disclaimer
The information in this article is of a general nature only and does not constitute personal financial or product advice. Any opinions or views expressed are those of the authors and do not represent those of people, institutions or organisations the owner may be associated with in a professional or personal capacity unless explicitly stated. Helen Baker is an authorised representative of BPW Partners Pty Ltd AFSL 548754.
