The short version
- Interest only means paying just the interest for one to five years.
- Repayments are lower at first, but rise sharply when the interest only time ends.
- You pay more interest overall, and the balance doesn't fall.
How interest-only works
For a set time, usually 1 to 5 years, your repayments cover only the interest. Your loan balance doesn't go down, and when the interest-only time ends your repayments rise, because you then repay the whole loan over fewer years.
Over the life of the loan you pay more interest than with principal and interest repayments, so weigh the lower repayments now against the higher cost later before you apply.
When it's used
- Building a home. While progress payments go to the builder and the loan isn't fully drawn, many construction loans are interest only, then switch to principal and interest once the home is finished.
- Bridging. If you buy a new home before selling your old one, a bridging loan covers both for a short time, and is usually interest only.
- Investing. Investors may be able to claim the interest on a rental property as a tax deduction, and keeping repayments low frees up cash while they hold the property.
- A short drop in income, such as during parental leave.
Stricter lending
Interest-only loans were once a common way to keep repayments down. Banks and the regulator, APRA, have since tightened the rules, so lenders now check that you could afford the higher repayments once the interest-only time ends. Rates are often higher than for principal and interest.
The risks
Because the balance doesn't fall, you build equity only if the home rises in value. If prices fall, you could owe more than the home is worth. Ask an accountant about the tax side before you choose interest only for an investment.
Pros
- Lower repayments for a time, which frees up cash.
- Investors may be able to deduct the interest while keeping repayments low.
- Useful during a build or a short drop in income.
Alternatives
- Principal and interest repayments, which pay the loan off and cost less overall.
- An offset account, which keeps cash on hand while cutting the interest you pay.
- A longer loan term, which lowers repayments while still paying the loan down.
How to apply
Most people get pre-approval for an interest only home loan before they start making offers, then the full approval once they've found a home.
- Get your documents together. Payslips, two years of tax returns if you're self-employed, bank statements showing your savings, and details of your debts and credit limits.
- Get pre-approval. It tells you how much you can borrow and shows sellers you're serious. It usually lasts three to six months.
- Find the home and sign the contract. The lender then values the property before it gives full approval.
- Settle. Your lender pays the seller, and your repayments start about a month later.
- Be ready to show you can afford the higher repayments once the interest only time ends. Lenders test it.
What to compare
Start with the rate for your situation: the rate a lender offers depends on whether you'll live in the home or rent it out, how you repay, and the size of your deposit. The comparison above picks each lender's rate for your choices.
Then look past the rate.
- Fees: upfront fees, and annual package fees that often come with an offset account.
- Features: an offset account, redraw, extra repayments and the option to split the loan between fixed and variable.
- The comparison rate, which adds standard fees to the rate for an example loan of $150,000 over 25 years.
- Any cashback, but only after the rate and fees, since a higher rate can cost far more over the life of the loan.