Pros & Cons of interest only loans

Should I pay Interest only on my loan?

An interest only home loan is when you the borrower only have to pay the interest of the loan plus fees, for a fixed period of time (usually up to five years). During this period, the repayments are a lot lower compared to a principal and interest home loan.

Once the interest only period ends, the home loan will revert to a principal and interest home loan over the remaining term. For example, if it was a 30 year loan initially with 5 years interest only, the new principal and interest repayments will be calculated over 25 years. This can be quite a large increase in repayments.

It is common for investors to take out interest only loans on investment properties. This strategy is often used while they pay a larger portion of their funds to their non-deductible debt like their home loan.

As with other financial commitments, interest only home loans have pros and cons attached. Listed below are just a few.

Pros

• Smaller repayments: For the 5-10 year interest only period, your monthly repayments will be significantly lower. This can be useful if you are currently under a tight budget and know you will be in a better financial position down the track. It can also be a suitable option if you are planning to spend money on renovating the property.

• Tax deductible: As the loan used for an investment property is tax deductible debt*, investors are often advised just to pay the interest and thereby receive an interest tax deduction for exactly what they pay. By not having to pay principal initially, you can put extra money towards your non-tax-deductible debts and funding other assets.

• Get your foot in the door sooner: As mentioned above, interest-only home loans may give buyers an opportunity to purchase a property without being initially overwhelmed with the full principal and interest repayments. An interest only loan could be an option for those who want to ease their way into the property market without spending too much initially.

Cons

• Without sufficient planning, you may find it hard to adjust to the new repayments: When we assess your ability to pay your loan we will be looking at your repayments when they are Principal and Interest. However you may fund that the jump in repayments after an interest only period requires some adjustments to your normal spending. You may also find that the interest rates will fluctuate quite a bit over the interest only period, and your rate could end up being significantly higher by the time your interest only period ends.

• You may pay more in interest: The longer you have your home loan (and the longer it takes to repay the principal owing), the more interest you will pay. If you are only making the minimum principal and interest payments after the interest only period ends, you could end up paying thousands of extra dollars in interest.

• You don't build equity: By only paying interest for the first 5-10 years, you are relying solely on capital growth to build equity. So, if you want to sell before the interest only period ends, you will still owe the full value of the mortgage and may not have any extra available.

What can you do to avoid some of the pitfalls?

If you decide to go ahead with an interest only loan we will discuss with you strategies to help you plan for the future. Some loans may have offset and redraw features which can help you to achieve your property goals.

We will work with you, before recommending a loan structure, to ensure we understand your future goals and can set up your loans accordingly.

We recommend seeking advice from a finance professional before implementing changes relating to your finances. Our accountants, solicitors and brokers are on hand to assist.