Finder is committed to editorial independence. While we receive compensation when you click links to partners, they do not influence our content.

Interest-only mortgages

Interest only mortgages start lower because you just pay off the interest. You pay more interest in the long run, but for the right borrower it can be a good option.

Avatar
Richard Whitten

&

Avatar
Sarah Megginson
Updated . What changed?
Fact checked

With an interest-only mortgage, you don’t repay the money you’ve borrowed at first. Instead, you pay off the interest on top, which makes your repayments much smaller. However, eventually, you have to repay the mortgage in full, and your payments get larger.

How interest-only mortgages work

There are two parts to any mortgage repayment: the principal and the interest.

  • The principal is the money you borrow from the lender. It’s also called the loan amount, which is the money you have to repay.
  • The lender charges the interest as a percentage of the money you borrow (the principal), which is how your lender makes a profit. The amount of interest the lender charges depends on the loan’s interest rate.

Most Kiwi borrowers choose principal and interest mortgages, so they borrow money and pay it back, plus interest at the same time.

With an interest-only mortgage, you borrow money, but you don’t pay it back at first. Instead, the lender charges interest, which you pay monthly.

However, the interest-only period doesn’t last forever. It usually only applies for 1 to 5 years, and when the mortgage reverts to principal and interest repayments, you have to repay both the principal and the interest together.

Here’s a quick example using two mortgages that are identical except for the repayments.

Interest-only mortgage repayments end up more expensive over time

DetailsPrincipal and interestInterest-only
Loan amount$500,000$500,000
Loan term30 years30 years
Interest rate2.70%2.70%
Interest only periodN/A2 years
Monthly repayments$2,027$1,125 (during interest only period)
$2,122 (after interest only period)
Total loan cost over 30 years$730,075$740,126
Difference in cost$10,051 cheaper$10,051 more expensive

In the scenarios above, we can see that two years of interest-only repayments, while much cheaper initially, end up costing you $10,000 more in the long run.

However, this is just a hypothetical example. In reality, interest-only mortgages have higher interest rates, so you pay slightly more. Plus, it’s also impossible to accurately calculate loan costs over 30 years because interest rates change over time.

What are the benefits of interest-only mortgages?

There are two significant reasons borrowers choose interest-only mortgages even though they cost more in the long run.

    Cheaper repayments right now

    While principal and interest repayments save you money in the long term, some borrowers need a break right now. In this case, interest-only repayments give you some breathing space because payments are much cheaper, which is helpful if you’ve lost income or are struggling to make repayments.

    It’s a short-term strategy, but if you’ve lost your job or are dealing with unexpected expenses, interest-only repayments can be a life-saver.

    Tax benefits for investors

    You can claim mortgage interest payments if you own an investment property, but not any principal loan payments.

    Let’s say you have an investment property loan worth $400,000. The interest-only repayments are $1,500 per month, while principal and interest repayments are $2,500.

    You can only claim the interest part of the payment ($1,500), so you, the investor, might decide to get an interest-only mortgage to:

    • Pay a lower amount each month
    • Keep your financial obligations low
    • Have a fully tax-deductible mortgage payment
    • Use the money you’re not paying on the loan principal towards another non-tax-deductible debt, like your own mortgage

    Some savvy investors buy a property in a booming market and then hold onto it for a few years. While the property grows in value, they pay off the loan interest and use it to reduce their tax bill. They also earn rent, which they might put into an offset account or save elsewhere.

    However, they never repay the mortgage. Instead, the investor sticks with interest-only repayments and then sells the property for a higher price.

    What are the risks with these mortgages?

    There’s nothing wrong with an interest-only mortgage. However, you need to be aware of the potential risks and understand what you’re getting yourself into.

    • Higher interest rates. Interest-only mortgages usually come with higher interest rates than principal and interest loans. But, of course, the repayments are still lower because you’re not paying back the loan amount yet.
    • You don’t build equity. If your property doesn’t grow in value, you won’t build equity in your home if you’re not repaying any of the principal, which means from the day you move into the property, you don’t own any more of it than the amount you paid for a deposit. You could even end up in negative equity if the property loses value.
    • You pay more interest. You have to repay the loan principal eventually, and by not repaying the principal from day one, the lender charges more interest.

    For the well-informed, well-organised borrower, an interest-only mortgage can work well. However, if you don’t know what you’re doing, it can get messy.

    Worst case scenario: Interest only loan and falling property prices

    Property prices in New Zealand tend to rise over time, but they can fall. If you have an interest-only mortgage and prices start to fall, you could end up with negative equity.

    Imagine you bought an investment property in 2017. For three years, you make interest-only repayments. You have trouble renting it out, but you are waiting for the property to grow in value.

    However, the market slows, and your property loses value, then your mortgage reverts to principal and interest.

    Now your repayments are much higher. You haven’t repaid any of your mortgage, and if you sell, you are still in debt, which is the worst outcome of having an interest-only mortgage. Most borrowers won’t find themselves in this situation, but it’s essential to understand the possible risks.

    How to compare interest-only mortgages

    Every borrower wants the best mortgage. Here’s what you need to do to find the best interest-only loan for you:

    • Compare and get a low rate mortgage. Every borrower benefits from a more competitive interest rate because it makes your repayments lower. Of course, it’s not the only factor you need to focus on, but the best interest-only mortgage for you has a rate that’s lower than most.
    • Find a loan with the right features. What features you need in an interest-only mortgage depend on your goals and strategy. For example, if you have extra cash lying around (or some savings), you can use a 100% offset account to save on interest charges. However, suppose you’re an investor, and you have an owner-occupier mortgage as well. In that case, you may want to keep your money there instead (because interest on investment loans is tax-deductible). In addition, some borrowers benefit from extra repayments, allowing them to repay their mortgage faster.
    • Add up the fees. Some mortgages slug you with monthly costs, which can add up to a few hundred dollars a year. Others come with a hefty one-off application charge, while others have no fees at all. So, if you can avoid fees, why not avoid them? Well, if there’s a better mortgage for you with a $200 fee attached, it could still be a more beneficial deal than a worse mortgage with no fee. Compare the entire mortgage, not just the charges.

    Interest only infographic

    Is it more difficult to get an interest-only mortgage?

    Lenders are still careful when assessing interest-only borrowers.

    Maximise the chances of getting your application approved by:

    • Saving a bigger deposit. Many banks are more willing to consider an interest-only mortgage if you have a lower loan-to-value ratio (LVR). A bigger deposit, usually at least 20%, makes you a more attractive borrower.
    • Making a plan. Lenders want to know why you want an interest-only mortgage versus a principal and interest loan. You are in a much better position if you can explain your justification for the mortgage and demonstrate your investment plans.
    • Talk to a mortgage broker. A broker’s job is to help you find a mortgage that suits your needs and financial situation. The broker vets your application before the lender does, maximising your chances of approval.

    All your interest-only questions answered

    More guides on Finder

    Go to site