Interest only mortgages vs principal & interest: which is right for you?

Most home loans in Australia include both principal and interest repayments. With this type of loan you pay interest, but you also slowly chip away at the principal (amount borrowed) of your loan, reducing it until you’re mortgage-free.

The other option is an interest-only home loan. This type of loan is exactly what it sounds like – you’ll only make interest repayments on your mortgage. While most Australian homeowners are better suited to principal-and-interest loans, there is a small group who might benefit from only paying interest. Let’s take a closer look.

THE PROS AND CONS

INTEREST ONLY

PROS:

• Lower repayments
• May have tax advantages for property investors

CONS:

• Does not reduce your loan principal
• Higher interest rate than principal-and-interest loans
• More interest paid over the life of the loan

PRINCIPAL AND INTEREST

PROS:

• Will pay off the principal of the loan so you’ll be mortgage-free sooner
• Lower interest rate than interest-only loans
• Pay less interest over the life of your loan

CONS:

• Higher repayments than interest-only loans
• May not have as many tax advantages as interest-only loans for property investors

HOW DO INTEREST ONLY LOANS WORK?

Interest only loans are usually for a set period of one to five years, after which the loan will revert to principal-and-interest repayments. You’ll only pay interest on the amount you’ve borrowed.

The amount of interest you pay can also be reduced if you’ve got savings or other cash to spare and you set up an offset account with your lender. An offset account links a savings account to your mortgage, which effectively reduces the size of your home loan and therefor the interest payable.

WHAT ARE THE RISKS OF INTEREST ONLY LOANS?

As fantastic as lower repayments sound, there are risks involved with interest only mortgages, including:

• Since you won’t be reducing the principal of your loan, if your property’s value decreases you could end up with a mortgage that’s worth more than your property.
• When your interest-only period ends, and your loan reverts to principal-and-interest, the size of your repayments will increase. If you haven’t planned for this increase and your budget is tight, that could well spell trouble.
• Interest-loans cost more. You’ll usually pay a higher interest rate and more interest over the life of your loan without reducing your principal.

Because of these risks, interest-only loans are only suited to certain people.

WHEN ARE INTEREST ONLY LOANS USEFUL?

There are generally three types of people who might find an interest only loan useful in certain circumstances:

1. Property investors.
2. Homeowners who are buying another property and are yet to sell their current home.
3. Homeowners who need to temporarily reduce their repayments due to their circumstances (for example, if a member of the household becomes unemployed).

For some investors, interest-only loans may have tax advantages, especially if they’re making a loss. Otherwise, investors may also secure an interest only loan on a property then wait for capital gains to kick in and sell the home for a profit. In other cases, an interest-only loan may be ideal to free up cashflow for other investments. So, it is all very much situationally dependent.

WHAT ABOUT PRINCIPAL AND INTEREST LOANS

For the vast majority of Australian property owners, a principal-and-interest loan is the way to go. The repayments may be higher but paying down your mortgage will allow you to slowly increase the equity in your home until you own it outright. You’ll also pay less interest over the life of the loan, especially if you’re in a position to pay yours off quickly.

Before you secure any type of home loan you should speak to a mortgage broker or trusted advisor to make sure that you can manage the risk, and that such a loan is the right choice for you. While the wrong choice could definitely hurt, the right choice could secure you a better, brighter financial future.