How interest-only mortgages work
Most mortgages are a principal and interest loan. You borrow money and repay it, plus interest; with the money you borrow called the principal.
With an interest-only mortgage, you only repay the interest on top, not the money you’ve borrowed. At first. When the loan reverts to principal and interest repayments, you have to repay both the principal and the interest together.
Interest-only mortgages start with much lower repayments. However, over time they cost you more because you have to pay more interest. They can be risky because the principal is the main part of the loan. If you’re not repaying the principal, you’re not really owning more of your home. You’re essentially borrowing money without actually paying it back (until you start paying off the principal).
Let’s compare two otherwise identical loans, one with principal and interest payments, the other with interest-only repayments for the first two years.
Interest only loan
- Loan amount: $500,000
- Loan term: 30 years
- Interest only period: 2 years
- Interest rate: 2.70%
- Monthly repayments (interest only period): $1,125
- Monthly repayments (remaining 28 years): $2,122
- Total cost of loan over 30 years: $740,126
Principal and interest loan
- Loan amount: $500,000
- Loan term: 30 years
- Interest rate: 2.70%
- Monthly repayments:
- Total cost of loan over 30 years: $730,075
What are the risks and benefits of interest-only mortgages?
- Lower repayments. Interest-only loans are cheaper at first. If you’re struggling to make repayments or want to pay off other debts, this loan type can help, for a while. However, in the long run, they won’t.
- High-growth investment. Property investors in booming markets often use interest-only loans. They buy a property, make small interest-only payments and watch the property grow in value. Then they sell it for a big profit, and they never need to repay the loan.
- Tax savings. If you’re an investor, your repayments may be tax-deductible, particularly if you use a 100% offset account. This is because interest on funds withdrawn from an offset account, rather than redrawing from your mortgage, is tax-deductible.
But the risks are obvious.
- No equity. If you’re not repaying the principal, you don’t really own more of your home. You could end up in negative equity.
- Revert. Repayments increase when the loan reverts to principal and interest.
- Higher interest rates. These mortgages usually come with higher interest rates.
For the well-informed, well-organised borrower, an interest-only loan can work well. However, if you don’t know what you’re doing it can get messy.
The interest-only trap
Imagine you bought an investment property in 2016, and for three years you made interest-only repayments. You had trouble renting it out, but you were waiting for the property to grow in value.
However, the market slowed and your property lost value, then your loan reverted to principal and interest.
Now your repayments are much higher and your property has decreased in value. You haven’t paid off any of your mortgage and if you sell you are still in debt.
This is the interest-only nightmare scenario.
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. If you can explain your justification for the loan and demonstrate your investment plans, you are in a much better position.
- Talk to a mortgage broker. A broker’s job is to help you find a loan that suits your needs and financial situation. The broker vets your application before the lender does, maximising your chances of approval.
What are the alternatives to an interest-only mortgage?
With an interest-only mortgage, you must repay what you borrow at the end of the term, for example, 2 years. There are a few ways to achieve this:
- Change to a repayment mortgage. To ensure you can meet the increased repayments, you need to receive approval by the lender. However, your borrowing falls every month, and at the end of the term, you have repaid the loan.
- Re-negotiate another interest-only mortgage. Try to lower the borrowing amount by making a lump-sum payment, as this adds equity to the property.
- Repay your mortgage with a lump sum. This may only be an option if you can liquidate another asset.
If you are having trouble repaying an interest-only mortgage, contact your lender
If you are struggling to repay your interest-only mortgage at the end of the term, it is important to act now and look for answers. The closer you leave it to the end of your mortgage term, the fewer options it leaves you. Make sure you contact your lender immediately to discuss what can be done.
If you are a first home buyer, interest-only mortgages are not as popular because the outstanding mortgage doesn’t decrease in amount. However, they could work for you if you only have a small mortgage left and you are going to repay it with savings, (at the end of the term).
