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Interest only mortgages how do they work

IInterest only mortgage imagenterest-only mortgages can be a useful home loan option in certain situations. An interest-only loan comes with lower costs for a short duration (usually up to 5 years). This can allow for greater flexibility to make other investments with your money, or to ease the pressure of repayments for that period. However, by delaying repayments of the balance owing on the home loan, an interest-only loan comes with certain risks. 

In this article, we offer a practical guide to interest-only home loans. The key questions we will answer are

  1. What is an interest-only mortgage? and
  2. How does an interest-only mortgage work?

We will also go through the main benefits and risks of an interest-only mortgage, comparing it to a standard home loan. 

What Is an Interest-Only Home Loan?

A standard home loan is usually called a ‘principal and interest home loan’. This means that you borrow a certain amount of money from a lender - the principal - and you have to pay this back over an agreed-upon time, plus interest.

An interest-only mortgage is a home loan in which you only pay back the interest on the loan. This means that the balance of the loan remains the same. The balance owing then needs to be repaid after the interest-only loan has ended. 

How Does an Interest-Only Home Loan Work?

An interest-only loan will have a fixed duration, typically of up to 5 years. It may also come with a different (often higher) interest rate to an interest rate applied when loan repayments are also being made. 

Lenders will usually offer interest-only loans as part of a larger home loan structure. For example, Greater Bank allows customers to incorporate interest-only loans of up to 5 years into most of its home loan products which have a total loan term of upto 30 years. The Ultimate, Great Rate, Investment Ultimate, and Investment Great Rate home loans all come with the option of an interest-only period of between 1 and 5 years.

During an interest-only term, you will only be required to make payments for the interest being accrued against the loan. Since you will not be making repayments against the principal itself, your loan repayments will be smaller than in a standard principal and interest loan. 

At the end of the interest-only term, the mortgage will need to be switched to a standard principal and interest loan. At this time, you will be required to start making payments against the principal itself. A new loan term and interest rate will also apply. 

Benefits of an Interest-Only Home Loan

The first and most obvious benefit of an interest-only mortgage is that repayments will be much lower in the short term. This might be a useful feature if you are able to make profitable investments during the interest-only term. 

For people who might struggle to make repayments for a short period, an interest-only loan can also help to ease the short-term pressure of the loan. This is particularly useful in periods of lower income (e.g. taking time off from work to raise children) or higher expenditure (e.g. supporting a dependent family member). 

An interest-only loan can also be useful when high growth is expected in the market. An interest-only loan can allow investors to buy properties with relatively low ongoing costs, before selling after a short turnaround for a large profit. | Greater Bank

If the property against which the loan is taken is an investment property, the interest repayments may be wholly or partially tax deductible. For this to be the case, you must be renting the property out, or have it available to rent. 

Risks and Disadvantages of an Interest-Only Home Loan

The first and most obvious disadvantage of an interest-only loan is that the loan will cost more in the long term. Since you are not making repayments against the loan itself, the amount of money you owe your lender does not decrease at all during the interest free period. This means you will pay a greater amount of total interest over the life of the loan. Secondly, the rates for Intrest Only loans are normally slightly higher.

An associated risk of the loan amount remaining the same is that you will be required to make higher payments than you are used to paying once the interest-only period has ended. Many borrowers find it difficult to adjust from interest-only payments to loan repayments plus interest. This is particularly the case if borrowers have not used their available funds to make good investments during the interest-only period.

Additional risks may occur if the property market does not act as the borrower expects. If the value of the property does not increase as expected - or if it depreciates - then it is possible that the borrower will be left with a loan they are not in a position to repay. Also, if the value of the loan is greater than the value of the property at the end of the interest-only period, it may be difficult to refinance. If attempting to sell the property, it might have to be done at a loss.

It can also be risky to take an interest-only loan in the event that your personal financial situation does not evolve as you expect. Sometimes borrowers will choose an interest-only loan, thinking that they will secure work, or that their income will rise significantly. If large unforeseen costs arise in your life, or costs that you thought were temporary do not go away, it may be very difficult to cope with the loan once the interest-only period has ended.

Is an Interest-Only Home Loan Right For Me?

Interest-only loans can be very beneficial in some circumstances, but they are not appropriate for everyone. In order to take out an interest-only loan, you need to be certain that you are going to be in a position to begin making larger repayments when the interest-only period ends. You need to be sure about your financial outlook for the years ahead, as well as the outlook for the value of your property. You also need to make sure that you can make the most of the interest-only period, which means saving and investing your money appropriately, as well as preparing yourself financially for when loan repayments begin. 

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