December 8, 2023

It’s Not Always a Fine Balance: The Pros and Cons of Interest Only Loans

It’s Not Always a Fine Balance: The Pros and Cons of Interest Only Loans

Recent APRA (that’s the Australian Prudential Regulation Authority or the guys who regulate the banks) figures show that over $27 billion of the loans approved in the September 2023 quarter for new residential housing - out of a total $150.9 billion - were interest-only loans. That means that 18.3% of loans for new houses are interest only loans. This tells us that more people who are building new homes are opting to pay only the interest on their loan, rather than paying off principal as well.

So, in effect, more people than ever before are paying the absolute bare minimum when it comes to new mortgages. You might be considering taking up this type of loan, as initially you will have lower repayments. However, it is important to understand the interest-only loans pros and cons, risks and benefits before going ahead!

How Do Interest-Only Loans Work?

Usually, mortgages are principal-and-interest loans. This means that by making repayments, the principal (or the total amount borrowed) and the interest are both being paid off. When someone takes out an interest-only loan, it means they are only paying off the interest on the amount of money they initially borrowed, but the amount of principal they are liable for stays the same. Interest free loans often only allow interest free terms for a limited amount of time, and at the end of this period, the principal and the interest becomes payable.  

Taking Advantage of the Interest-Only Period

Taking advantage of the interest-only period

Consider for example, if a couple were to take out a mortgage over a 25-year period with an interest-only period of 5 years. If they set up their loan with an offset account, they can choose to pay extra which will cover the interest repayments and accumulate the surplus into redraw (depending on the terms of the contract).

This is the best way to use an interest-only home loan, as if paying the extra money gets too much, you can reduce the repayments or withdraw the additional funds as needed (i.e. in the case of an emergency). Interest-only home loans can also be a good short-term financing option for those who are in between selling their old property and buying a new one (bridging finance), or for those who are building from scratch with a construction loan.

Investors may also be able to make capital gains by flipping property (i.e. buying at $500K and selling at $600K), or by claiming tax benefits with the use of interest only financing. 

The Risks of Interest-Only Loans

There are a number of risks you should consider before signing up for an interest-only mortgage. Firstly, often the interest rate on interest only loans are higher than interest rates on normal principal + interest loans. So in the long run, you may end up paying more over the life of the loan.

Further, because you don’t pay anything towards the principal amount during the interest-only term, the total amount doesn’t reduce, and this can leave you in a sticky situation. For instance, you might take out an interest-only loan with the best intentions of using an offset account to save money and to be more prepared for the interest and principal period of your loan.

However, not only is the lure of all that money sitting in an offset account too much for some people, it is also risky if the value of your house doesn’t increase over time. If this should happen, you risk having no equity in your home despite the fact you have made interest payments every month or fortnight.

Having no equity in your home is not a good scenario to be in, because if there is a downturn in the property market or you have a change in personal circumstances, you may end up having to sell your house at a loss.

Another big thing to consider when taking out an interest only loan, is that repayments can increase quite significantly to cover the new rate when the interest-only term ends. Drastic increases in repayments can hinder your best efforts to make ends meet without an increase in your income.

Read More: How to Get a Mortgage with Bad Credit after Bankruptcy

Managing a Calculated Risk

managing a calculated risk of interest free loans

Managing your personal finances, particularly when you take on a home loan, takes real commitment and self-control. Whilst interest-only loans can help in the short term, if you don’t prepare to increase your income or save, then your future self might end up bitterly disappointed that your present self didn’t make better choices.

First and foremost, before signing the contract on any interest only loan, calculate the cost of repayments once the interest only period expires to ensure you can afford the elevated repayments. Also be mindful to give yourself some room to move in case interest rates do rise (to learn more about interest rates, check out Interest Rates in Australia 2023 published by Reserve Bank of Australia). Some more practical tips to help you handle the transition of your loan to principal and interest:

- Slowly Increase Repayments

If you are able to make additional repayments, gradually increase them in anticipation of the shift. Confirm when and how much the payments will increase. For example, if they are due to increase by $1,500 a month in a 12 months’ time, take the opportunity to start repaying $150 per month.

- Shop Around

Don’t feel obliged to stay with your current lender – as a consumer you wield the power of choice, and by shopping around to find a better rate on a similar loan, you will have the leverage to get your lender to price match or give you a better deal – otherwise you can threaten to jump ship. If they don’t want to negotiate, you can even try changing home loans – just make sure you do your research to make sure that the benefits of switching outweigh the costs!

- Discuss Options with Your Lender

If you don’t think you can manage increased repayments, speak with your lender about altering the loan terms, reducing the repayment amount or seeking a temporary pause/applying for hardship.

Before you sign up, always be sure to research interest-only loans pros and cons before you sign up for financial products such as interest-only home loans. As always, plan for all possible scenarios, be prepared, do your research, and don’t over-commit yourself.

If you are currently in a bad financial situation and you are struggling to get on top of your finances, you might need some professional help. Our expert team of Credit Counsellors have helped thousands of Australians to overcome debt struggles and get their finances back on track. If you need of this kind of assistance, call us on 1300 003 328 for an obligation-free assessment

Recent Articles