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A guide to interest-only loans

There’s a lot to weigh up when deciding loan types. But you don’t have to decide on your own – a Loan Market broker will advise you on the right loan for your circumstances.

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interest only loans

Short on time? Here’s a quick summary:

  • Interest-only loans allow you to pay only interest charges for a set period to keep initial repayments lower.
  • Once the interest-only period ends, your repayments will increase because you will have a shorter timeframe to pay off the full loan balance.
  • Investors often choose this option to potentially maximise tax deductions on interest payments while using the extra cash flow to help fund future goals.

Interest-only loans explained

When you apply for a mortgage, you can choose between a principal-and-interest (P&I) loan and an interest-only (IO) loan.

With a P&I loan, you simultaneously pay interest and pay off some of the outstanding loan (also known as the principal) when you make your repayments.

But with an IO loan, you pay nothing but interest when you make your repayments. As a result, your repayments are lower, at least during the IO period. At some point though, your loan reverts from IO to P&I, at which point your repayments rise.

Let’s look at an example: Imagine you were taking out a $500,000 loan, with a 30-year term and a 6% p.a. interest rate.

  • If you chose the P&I option: your repayments would be $2,998 per month, or $1,079,191 over 30 years.
  • If you chose an IO loan (for the first 5 years): your repayments would initially be less – $2,500 per month. However, when the loan reverted to P&I for the final 25 years, your repayments would be higher – $3,222 per month. (That’s because you’d now have 25 years to pay off the $500,000 principal, rather than 30 years.) Also, your total repayments over the 30-year term would be higher – $1,116,452.

The pros and cons of an interest-only loan

As with all finance products, there are trade-offs involved with IO loans:

  • The upside is your repayments are lower during the IO period.
  • The downside is your repayments are higher when the loan reverts to P&I and you pay more over the life of the loan.
  • Another downside is that the interest rate is usually higher for IO loans than P&I.

Three reasons borrowers may choose interest-only loans

  1. Preserve funds. They have limited disposable income at the time they apply for the mortgage, but expect to have more in the future – for example, when a new business takes off, or one member of the household returns to work or a child leaves home.
  2. Maximise tax benefits. Interest-only loans are popular with investors because, unlike owner-occupiers, investors are allowed to claim a tax deduction for interest payments (but not principal repayments). They can then use the money they save to help fund the deposit on a future investment property.
  3. Prepare for a future sale. If a buyer expects to sell the property in a few years, they may prefer to go IO in order to limit their expenses before selling.

Deciding between principal and interest or interest-only repayments depends on your financial goals. Reach out to a Loan Market broker today to find the right loan for your situation.

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FAQS

Common questions about interest-only loans .

What happens when the interest-only period ends?

When your interest-only period expires (typically after 1 to 5 years), your loan automatically reverts to a principal-and-interest (P&I) repayment structure. Because you now have a shorter remaining loan term to pay off the original principal amount, your monthly repayments will increase significantly.

Are the interest rates higher for interest-only loans?

Generally, yes. Lenders usually consider interest-only loans to carry a slightly higher risk than P&I loans. As a result, interest-only home loans frequently have higher interest rates compared to standard principal-and-interest loans.

Can I make extra repayments to pay down the principal during the interest-only period?

This depends on your lender and the specific terms of your loan. Many variable-rate interest-only loans allow you to make extra repayments without penalty, meaning you can chip away at the principal if you have extra cash. However, fixed-rate interest-only loans often cap the amount of extra repayments you can make, or they may charge break fees if you exceed the limit.

Can I extend my interest-only period once it expires?

In some cases, yes, but it is not automatic. You will need to formally apply for an extension with your lender, and they will reassess your current financial situation, income, and equity to ensure you can still comfortably afford the loan. Lenders usually cap the maximum consecutive interest-only period (often at 5 to 10 years total).