As ASIC and the lenders continue to tighten lending policies, there has been a lot of discussion recently about interest-only loans.

The government’s Money Smart website has produced this useful information to help borrowers better understand interest-only loans and the risks associated with them.

Is it in your interest?

As the name suggests, with an interest-only mortgage your repayments only cover the interest on the amount you have borrowed, during the interest-only period.

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. Here we explain the risks and benefits of interest-only mortgages.

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 (usually up to 5 years). 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. Before you take out an interest-only home loan, you'll need to work out if you can afford the increased repayments.

Work out your repayments before and after the interest-only period using ASIC’s MoneySmart interest-only mortgage calculator: https://www.moneysmart.gov.au/tools-and-resources/calculators-and-apps/interest-only-mortgage-calculator

Australia's interest-only mortgages

Take a look at ASIC’s MoneySmart interest-only mortgages infographic which explains how interest-only mortgages have grown in Australia, how much people are borrowing for an interest-only loan and how much you will really pay for this type of loan: https://www.moneysmart.gov.au/borrowing-and-credit/home-loans/interest-only-mortgages/australias-interest-only-mortgages

Using an offset account on an interest-only loan

Some people make extra payments into an offset account to reduce the amount of interest they pay on their home loan.

This is a good strategy with an interest-only loan but it will only work if you can keep making these extra repayments without making any withdrawals. If you're tempted to dip into your offset account, then you might be better off with a principal-and-interest loan instead.

Case study: Violet and James get an interest-only loan

Violet and James took out a $500,000 home loan over 25 years, with an interest-only period of 5 years. They planned to reduce the interest they paid on the loan by making extra payments into an offset account.

After 2 years, they decided to go overseas for a few months and started withdrawing money from the offset account to cover their trip. When they returned from the trip they had a big credit card bill to pay off so they no longer had enough money to make extra payments into the offset account.

When the interest-only period ended, they only had 20 years to repay the entire $500,000 principal, so their repayments were suddenly a lot higher and they struggled to keep up with all their bills.

Risks of interest-only home loans

Interest-only home loans seem more affordable because their repayments are initially lower than principal-and-interest home loans, but they will cost you much more in the long run.

The extra interest you'll pay on an interest-only loan

During the interest-only period, you do not reduce the amount of money you owe, which means you'll end up paying a lot more interest over the life of the loan, compared to a principal-and-interest loan. For example, with a $500,000, 25-year loan, with an interest rate of 5%, a person would pay $40,062 more in interest with an interest-only loan compared to a comparable principal-and-interest loan.

Increase in repayments after the interest-only period ends

Once the interest-only period ends you need to start repaying both interest and the principal, and you'll have less time to do it in. This means the repayments after the interest-only period will be significantly larger.

Case study: Daisy's interest-only loan repayments

Daisy wants to buy her dream apartment and has been looking online at the different loans available. She needs to borrow $500,000, the interest rate advertised is 5% and she wants to repay the loan over 25 years.

Daisy is deciding whether a loan with an interest-only period of 5 years or a principal-and-interest loan would be best for her. She was worried that she might not be able to meet loan repayments after the interest-only period ends.

Daisy used ASIC's MoneySmart's interest-only mortgage calculator to see what the repayments on an interest-only loan would be compared to a principal-and-interest loan.

While the initial repayments on the interest-only loan were only $2,083 per month, after the interest-only period ends they increase to $3,300.

Daisy didn't think that she would be able to afford the increased monthly repayments, when the interest-only period ends. She decided that a principal-and-interest mortgage, with constant repayments of $2,923 would better suit her budget.

No equity in your home

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. Holding no equity in your home puts you in a risky position if there is a downturn in the market or your circumstances change and you have to sell the house.

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. You can also use the money saved from lower repayments to repay higher interest loans like credit cards and personal loans.

Some people choose interest-only loans to maximise their tax benefits or the amount they can borrow when they buy an investment property. If you're considering an interest-only loan, think carefully about whether it's the right loan for you, or contact our Leasing & Finance team for assistance.