How Do Interest-Only Home Loans Work?

An interest-only home loan lets you pay the interest charged on your loan for an agreed period without being required to repay the principal.

Because you are not paying down the loan balance, your minimum repayments are lower during the interest-only period. The trade-off comes later: you still have the principal to repay, usually over fewer years, so repayments can rise when the interest-only period ends.

For property investors, this can make interest-only loans useful as a cashflow tool. But the decision needs to account for more than the repayment today. The cost over the life of the loan, the repayment after interest only ends, and the effect on future borrowing capacity can all matter.

What is an interest-only loan?

With a standard principal-and-interest (P&I) home loan, each repayment goes towards both the interest charged and the amount you borrowed.

With an interest-only (IO) loan, your required repayments initially cover the interest charged on the outstanding balance.

Say you owe $600,000 and the interest rate is 6.00% p.a. An interest-only repayment would be about $3,000 a month, assuming monthly interest and no fees.

After making that repayment, you would generally still owe $600,000.

That continues until the agreed interest-only period ends or you make additional repayments towards the principal yourself.

The loan will usually then move to principal-and-interest repayments.

How Does An Interest-only Loan Work?

An interest-only period sits within the overall term of the home loan.

For example, you might take a 30-year loan with the first five years set to interest only. Once those five years have passed, the outstanding principal needs to be repaid over the remaining 25 years.

That can create a noticeable jump in repayments.

Using a $600,000 loan at an illustrative 6.00% p.a.:

• A 30-year principal-and-interest repayment would be about $3,597 a month.
• The interest-only repayment would be about $3,000 a month.
• After five years of interest only, the repayment would rise to about $3,866 a month if the rate remained at 6.00%.

Assuming the rate stayed unchanged for the full 30 years and ignoring fees, using interest only for the first five years would also result in roughly $44,700 more interest over the life of the loan.

Actual repayments will depend on your rate, loan term, IO period and any additional repayments you make.

Look at the repayment after interest only ends

It is easy to focus on how much an IO loan saves in monthly repayments today.

The figure we think deserves just as much attention is the repayment that follows.

If the interest-only period ended tomorrow, would the principal-and-interest repayment still fit comfortably within your budget?

That gives you a better indication of whether the structure remains manageable beyond the initial IO period.

Interest only loan calculator

Our Interest-Only Loan Calculator can help you compare interest-only and principal-and-interest repayments.

You can use it to see:

• Your repayment during the IO period.
• What the repayment could become afterwards.
• The monthly cash-flow difference between IO and P&I.
• How the IO period changes the total interest paid.
• The effect of having fewer years left to repay the principal.

If you need help with getting a home loan, call 1300 889 743 or complete our free assessment form to speak with one of our mortgage brokers.

Is it worth getting an interest-only mortgage?

It can be worth getting an interest-only mortgage if the lower repayments serve a clear purpose, such as preserving cash for another property purchase, maintaining a larger buffer or improving short-term investment cash flow.

However, the benefit is temporary. During the interest-only period, you are generally not reducing the loan principal, so you will usually pay more interest over the life of the loan. Your repayments can also rise when the interest-only period ends because the remaining debt must be repaid over a shorter period.

For property investors, our brokers would also look at how the IO loan could affect future borrowing capacity and whether the higher post-IO repayment still fits the overall strategy.

The important distinction is that a lower IO repayment comes from postponing repayment of the principal.

You are not receiving the same type of saving you would get from reducing the interest rate.

Who can get an interest-only loan?

Interest-only lending is available to both investors and some owner-occupiers, although the options and assessment criteria can differ.

• The lender will still assess whether you can afford the debt. Your income, expenses, existing loans, credit cards and other commitments are taken into account, along with the property and the amount you want to borrow.
• Your LVR can also affect which lenders and IO terms are available. Higher-LVR applications generally have fewer options.
• Some lenders will also want to understand why you are requesting interest only, particularly for an owner-occupied home.
• The length of the IO period matters as well. The longer you spend paying interest only, the less time remains to repay the principal within the original loan term.

For investors, there is another question worth considering before choosing a lender: what will this loan look like when you apply for the next one?

How can interest only affect borrowing power?

A lower monthly repayment does not necessarily mean a lender will assess the debt more favourably.

When lenders work out borrowing capacity, they generally assess repayments at a higher rate than the rate you actually pay. They can also take the remaining term of an interest-only loan into account.

Suppose you have a 30-year loan with five years interest only.

You may only be paying interest today, but the principal still needs to be repaid over the remaining 25 years. The lender assessing your next application may allow for that higher future repayment.

This is one reason an investor can have comfortable day-to-day cash flow but receive a lower borrowing-capacity result than expected.

Lenders do not all assess existing debts in exactly the same way either. Two lenders can look at the same income, expenses and mortgages and arrive at different borrowing-capacity figures.

Think about the next property before choosing the current loan

When our brokers review an investor who intends to buy again, the current loan is only part of the picture.

They also consider how much borrowing capacity is likely to remain after settlement, how the new debt could be treated by lenders later and whether there is enough cash left for the next deposit or unexpected property costs.

The lowest repayment today is not always the most useful structure for the next purchase.

This becomes more important as a portfolio grows. A structure that works well for the first property can become restrictive if it uses too much borrowing capacity or makes refinancing difficult later.

When can interest-only repayments make sense?

Interest only tends to be most useful when the cash-flow difference has a clear purpose.

An investor might want to keep more money available for another deposit, maintain a larger cash buffer, cover renovation or property expenses, or direct cash towards other debt.

It can also form part of some construction or short-term lending arrangements.

What matters is what happens to the money you are no longer putting towards principal.

If the lower repayment simply disappears into normal spending, you can reach the end of the IO period with essentially the same mortgage balance and a higher required repayment ahead of you.

For investors, that is worth thinking through before the loan is set up rather than at the point the IO period expires.

Is interest-only better for an investment property?

It depends on what you are trying to achieve.

Some investors favour interest only because it improves short-term cash flow. Others prefer to reduce the debt from the beginning and pay less interest over time.

The rate also matters. Interest-only investment loans can be priced differently from P&I loans, so the repayment difference is not determined by the repayment type alone.

If you expect to buy another property, borrowing capacity and available cash may carry more weight in the decision.

If you have no plans to expand the portfolio and can comfortably make P&I repayments, reducing the principal earlier may be more important.

There is no useful rule that every investor should choose one repayment type.

The better comparison is between the cost, cash flow and flexibility of each structure for your particular plans.

Are interest-only repayments tax-deductible?

The tax treatment depends on what the borrowed money was used for.

For a rental property, interest may be deductible where the borrowed funds were used for an income-producing purpose and the relevant tax rules are met.

On a P&I repayment, the principal component is not interest and is generally treated differently for tax purposes.

Choosing an interest-only repayment type does not by itself determine whether the interest is deductible.

This becomes particularly important when a loan has been refinanced, redrawn or used for more than one purpose.

A mortgage broker can explain how the lending can be structured, but tax advice should come from a registered tax professional.

What happens when the interest-only period ends?

Your loan will generally switch to principal-and-interest repayments unless another arrangement has been approved.

The size of the increase depends on the amount still owing, your remaining loan term and the interest rate at the time.

For example, someone who has five years left on an IO period today could face a very different repayment environment when those five years are up.

That is why it helps to review the loan before the expiry date arrives.

At Home Loan Experts, an IO expiry review can look at the expected new repayment, whether the current loan still suits the borrower and whether refinancing or restructuring is worth investigating.

Do not assume another interest-only period will automatically be available.

Can I extend an interest-only period?

Possibly.

An extension is normally subject to the lender’s policy at the time and your current financial position.

The lender may reassess your income, expenses, liabilities, repayment history and property position. It may also limit how much total time the loan can remain interest only.

If your existing lender will not approve another IO period, refinancing may be an option, provided you qualify with another lender and changing loans makes financial sense.

It is usually easier to assess those options before the current IO period expires than after repayments have already increased.

Can an offset account be used with an interest-only loan?

Some interest-only loans allow an offset account.

Money held in a 100% offset account reduces the loan balance used to calculate interest while the money remains in the account.

For example, if your loan balance is $800,000 and you keep $300,000 in an offset account, interest would generally be calculated on $500,000.

That can give borrowers a way to reduce interest while keeping their cash accessible.

For property investors, there can be tax differences between keeping money in an offset account and making additional repayments into a loan before later redrawing the funds.

Speak with a tax professional before making decisions based on future deductibility.

What happens if property prices fall while I am paying interest only?

Your equity is affected by both the loan balance and the value of the property.

When you are making minimum interest-only repayments, you are generally not reducing the loan principal. If the property value falls at the same time, your LVR can increase.

That can make refinancing harder, particularly if you are relying on refinancing to obtain another IO period when the existing one expires.

For investors using IO as part of a longer-term strategy, it is worth considering how the plan works if property values stay flat or fall rather than relying on capital growth to improve the equity position.

Should I switch to interest-only if repayments are becoming difficult?

If you are struggling to make your mortgage repayments, contact your lender or broker early.

Moving to interest only may reduce repayments in some situations, but approval is not automatic and it may increase the long-term cost of the loan.

Your lender may also have hardship arrangements or other repayment options available.

The earlier you raise the issue, the more time there usually is to explore the available options.

Talk to us about your interest-only options

Interest only can improve cash flow, but the repayment during the IO period is only one part of the decision.

If you are investing, refinancing or approaching the end of an existing interest-only period, Home Loan Experts can review how the loan would affect your repayments now, what happens later and how the structure could influence future borrowing.