Interest only loans have traditionally been tailored to investors so they can reduce their mortgage repayments and maximise their tax benefits and overall return on investment (ROI).
However, getting home loan with interest only (IO) has its place and some lenders are willing to consider your application if you can provide valid reasons.
Do I qualify?
- Acceptable at 90% of the property value: Most lenders will only consider interest only if your home loan is 80% or less of the property value (up to 80% Loan to Value Ratio) but some lenders will allow up to 95% if you can meet strict lending criteria.
- You must provide good reasoning: In some cases, you may also need to provide evidence for choosing IO over principal and interest repayments.
- Strong financial position: You need to have a strong enough income to afford principal and interest (P&I) repayments once your interest only term expires.
- Strong credit history: You need to have a solid history of making debt and bill payments on time and your credit file should be clear of black marks.
- Interest rates: You can still qualify for home loan rates as long as you’re not investing (fixed rates aren’t available).
- Home loan features: Basic and professional packages are available, including access to an offset account and a redraw facility.
Please call us on 1300 889 743 or fill in our free assessment form and we can let you know if you qualify for a home loan with interest only.
What are valid reasons for choosing interest only as a homeowner?
Interest only for homeowners
Starting a family
You’ve either just had a child or you’re expecting one soon so you or partner are dropping to part-time work.
Generally, you need to provide a letter from your employer confirming your level income prior to going on maternity leave and that you’ll be able to return to work on the same income by the time P&I repayments kick in.
Building a house or renovating
Construction loans are typically interest only during the building process (up to 12 months).
However, if you’re planning to undertake renovation work on your house such as extensions, landscaping, redoing kitchens and bathrooms, and more, banks may allow you to switch to interest only for 1 year.
Note that work that takes more than a year to complete will generally be considered as construction which means you’ll need to meet specific lending crtieria.
They will typically allow interest only for 1-2 years as long as you can provide quotes for the building or renovation work and show proof that you will continue to work during this time.
Planning to sell in the near future
Banks don’t like speculative investing but if your plan is to sell your own home in the next year, they may allow you to make interest only payments during this period.
They will undertake a valuation of the property and if they’re confident that the market won’t take a sudden turn, they may consider your application.
Becoming injured or sick
Sometimes life can throw you a curveball and you may find yourself suffering temporary injury or sickness that prevents you from working or at least undertaking full-time work.
This can make a significant dent to you and your partner’s combined income and see you struggling to make P&I repayments.
Making interest only payments can be a short-term solution to allow you to get back on your feet, cover any medical costs that you incur and decide what your long-term goal is i.e. whether you sell the property and downsize or if you or your partner can get a second job.
Luckily, some borrowers come out the other side with their employer supporting them in getting back to full-time duties.
As such, your lender may ask you to provide an employment letter and medical reports as proof of your incapacity and your ability to eventually return to your standard wages.
Investing in property
It’s common for people to use the equity in their property to purchase an investment property.
However, loan increases or loan top-ups will generally be treated as an investment loan even though you’ve increased the mortgage on the property you actually live in (owner-occupied property).
So lenders will consider interest only on this loan but you should be aware that you’ll be hit with higher investment loan rates.
Maximise business cashflow
Sometimes you may require repayment flexibility due to inconsistencies in yourbusiness cashflow.
That’s not to say that a lender will approve IO if you’re self-employed and have been struggling to turn a profit.
However, some lenders do recognise that business income can fluctuate, particularly for retail businesses that earn less profit at certain times of the year and more around the Christmas and school holiday period, for example.
As with any other self employed borrower, you’ll generally need to provide your last two years tax returns showing that your income has overall been consistent.
Maximise personal cashflow due to financial hardship
It’s very rare but sometimes lenders will consider other types of financial hardship irrespective of you being PAYG or self employed.
Interest only payments is one way to help you get back on your feet. Temporarily pausing your repayments is another.
This will only be approved in exceptional circumstances so the more evidence you can provide, the stronger your application will be.
It’s not uncommon to accumulate a number of credit cards, a personal loan or a car loan since getting your mortgage.
This can put a lot of financial stress on some borrowers because you’ll be paying a much higher interest rate with this type of credit than the rates on a home loan.
As long as you’ve been making all of your repayment on time across all of your accounts, including your home loan, you may be able to refinance to a lender that will consolidate your debts and allow you to make interest only payments for the first 1-2 years.
The last thing your lender wants is for you to default on your mortgage so they may be willing to accommodate IO payments, at least in the short-term.
Other reasons for switching to interest only will be assessed on a case by case basis such as paying for a wedding.
Interest only for first home buyers
It’s quite common for first home buyers to have put most of their savings into their deposit and to cover the costs of buying a home.
This can leave their financials a little tight in the short-term, although their overall financial situation and income is strong.
Reasons that are typically considered include:
- Easing into the realities of making regular mortgage repayments and getting used to setting a budget.
- Buying furniture and other items for the house.
- Building a buffer to cover bills and mortgage repayments in the event that interest rates suddenly rise.
- Covering the cost of minor renovation work if you’ve purchased a fixer-upper.
- Borrowers who know either they or their partner will be on higher incomes in the next year or two and will more easily be able to afford P&I repayments.
Buying a new home
Ideally, when selling a new home and upgrading to a new one, you’ll make a profit from the sale.
This means you’ll need a much smaller mortgage to buy the new property.
However, there are costs when selling and buying a new home that can catch borrowers off guard including:
- Undertaking minor repairs and cosmetic work to your old home before selling.
- Moving costs.
- Real estate agent fees.
- Purchasing new furniture.
- Other costs.
Again, this can leave a borrower’s funds stretched depending on how much they sold their property for, how much their new property is worth and how much you’re able to contribute towards the purchase of the new property.
Unacceptable reasons for interest only
- Wanting to maintain the same high-cost lifestyle prior to getting a home loan.
- Buying a car.
- Travelling or going on an expensive holiday.
- Buying other luxury items like a boat or an entertainment system.
- Wanting to get a personal loan or credit for any number of other lifestyle reasons.
Will I pay a higher interest rate?
No, you won’t.
You can still qualify for a standard residential home loan rates as long as the purpose of switching to interest only isn’t for investment purposes.
What documents do I need to provide?
It depends on what your reason is for choosing interest only but document requirements typically include the following.
- Your two most recent payslips.
- (Optional) A letter from your employer confirming your income.
- (Optional) Your last year’s group certificate.
- Two years personal tax returns.
- Two years personal tax assessment notices.
- Two years company/partnership/trust tax returns.
- Two years financial statements (if available).
- Most recent statement and transaction history for the last six months for your home loan that is being refinanced.
- Most recent statement for any home loans not being refinanced (if applicable).
- Most recent credit card statement (if applicable).
- Most recent personal loan statement (if applicable). This includes car loans.
Are banks more likely to approve for lower LVRs?
If you’re a current mortgage holder and you owe less than 80% of the property value (80% Loan to Value Ratio) on your mortgage, banks are more willing to approve interest only.
Will banks limit the interest only term if they see a potential risk?
When it comes to approving interest only, banks want to see a valid reason.
For example, let’s say that you’ve been making your mortgage repayments on time, every time over the past 5 years.
You’ve even been making extra repayments every fortnight as a scheduled payment and have only used redraw twice over the past 5 years.
You ask the bank if you can switch to interest only for 2 years because you and your husband are expecting a baby.
After maternity leave, you will be taking a year off, after which, you will be returning to full-time work on the same income.
The banks may consider this with proof.
The point is, banks will only approve an interest only term that matches your risk profile.
Golden tips for managing a home loan with interest only
A home loan with interest only isn’t a way to get out making mortgage repayments: banks want their money back with interest eventually!
You have to be disciplined and put as much of the principal payments that you’re not paying into an offset or redraw facility.
Either facility will help you to reduce your interest bill but by putting the extra funds into a redraw, you’re actually reduce your principal owing and still have the option to redraw if you need to.
Just bear in mind that as soon as your redraw, your fortnightly or monthly mortgage repayments will shoot back up again so it’s a catch-22.
Call us on 1300 889 743 or complete our free assessment form and we can let you know if a home loan with interest only is right for you.
Who shouldn’t get a home loan with interest only?
Generally speaking, you shouldn’t choose interest only if you would otherwise struggle, financially, to make P&I repayments.
In particular, it’s not a good sign to the banks when you need an interest only term when interest rates are historically low.
If you can only afford to make interest only payments now, you should really be considering how you will be able to make principal and interest (P&I) repayments when your loan reverts to P&I and//or when rate invariably rise.
Banks use their own calculations when assessing IO applications, typically assessing your ability repay the mortgage over 25 years rather than the typical 30-year term (for a 5-year interest only term).
They even apply an interest rate buffer to work out whether your income would be able to support P&I repayments if interest rates were to rise 3-4 basis points.
However, in the end, only you know your medium-to-long term goals so you should be realistic as to whether you can easily make the switch to back to P&I when the time comes.
What are the other drawbacks?
- Fixed rates aren’t available: This could leave you in a tough financial position should interest rates rise.
- You pay more interest in the long run: The longer you have your home loan for, the more interest you’ll end up paying at the end of the loan term (use the IO versus P&I calculator to see for yourself).
- Only short interest only terms available: Typically 1-2 years and hardly ever up to 5 years (extensions are typically not available either), unless you have plans to invest in property or shares.
Not only are you not paying down the mortgage but you’re not maximising your equity either.
What does that matter if I’m not planning to use my equity buy another property? That’s actually not the issue.
If the property market takes a turn for the worse and you’re forced to quickly, you may have to sell at a loss.
Worse still, you could be left owing money to the bank (left exposed) depending on your LVR when you applied for IO.
For example, let’s say that you switched to interest payments on a $480,000 mortgage on a property worth $600,000 (80% LVR).
Your interest rate is 3.90% and your IO term is for 3 years, after which you switch back to making P&I repayments.
Over the next two years, the local property market enters a severe downturn and you find that your property is now worth $490,000 and you’ve only paid down your principal to $461,860.
Taking into account real estate agent fees and the other costs of selling a property, it costs you around $15,000 (best case) to sell the property.
Your profit after selling and paying of your mortgage is around $13,140 or $490,000 – ($461,860 + $15,000).
If you were to instead make P&I over that 5 year period, you would have paid down your mortgage to $432,010, bringing your total profit from the sale to $42,990.
Your monthly repayments would have been $2,209 compared to $1,480 over the 3-year interest only term saving you $26,244. Try the mortgage repayment calculator to see for yourself.
However, if you were to minus this $26,244 saving from your $42,990 profit from making P&I repayments over 5 years, your total profit after selling would be $16,746.
This means you would still have been $3,000 better off making P&I repayments over the entire 5-year period ($16,746 – $13,140) than paying interest only for 3 years.
Consider your long-term plans
The fact is, you don’t get the same tax benefits as an investor if you make a loss on your property.
Instead, you should really aim to build as much equity as possible by reducing your LVR in order to steer clear of any potential hardship should interest rates rise or your situation change.
By reducing your principal total (your actual loan amount without interest payments), you’re reducing your interest payable and, effectively, the size of your fortnightly or monthly mortgage repayments.
This strategy makes sense if you plan to stay in your house for the rest of your life or until you reach retirement.
Do you need an interest only home loan?
There can be legitimate benefits to getting a home loan with interest only.
Call us on 1300 889 743 or complete our free assessment form and we can let you know if you qualify.