With an interest-only loan your repayments only cover the interest on the amount you have borrowed.
You might consider this type of loan if you’re buying a house or refinancing your mortgage, but you need to think carefully about whether it will be the best loan for you in the long run.
How do interest-only loans work?
Most home loans are principal-and-interest loans, which means that your regular payments will reduce the principal (amount borrowed) as well as paying off the interest.
With an interest-only loan, you only pay interest on the amount you have borrowed for an agreed period. At the end of this time, the loan reverts to a principal and interest loan and you start repaying the principal as well as the interest.
Important: Before you take out an interest-only home loan, you’ll need to work out if you can afford the increased repayments when the interest-only period ends.
Using an offset account on an interest-only loan
You might like to make extra payments into a Mortgage Offset Account to reduce the amount of interest you pay on your home loan.
Benefits of interest-only home loans
If you will make extra repayments during the interest-only period, and you can cover the extra payments when the loan reverts to principal and interest, an interest-only loan might work for you.
Risks of interest-only home loans
Interest-only home loans seem more affordable because repayments are initially lower than principal and interest home loans, but they will cost you much more in the long run.
During the interest-only period, you do not reduce the amount of money you owe, which means you’ll end up paying more interest over the life of the loan, as well as higher repayments when the interest-only period ends.
Once the interest-only period ends you need to start repaying the principal, and you’ll have less time to do it in.
For example, if you take out a 30-year loan with a 5-year interest-only period, you will only have 25 years to pay back the principal when the interest-only period ends. This means your repayments will be much higher than if you only had a principal-and-interest home loan from the start.
If your property does not increase in value during the interest-only period, you risk having no equity in your home at the end of this period, despite making payments every month.