Interest-only Home Loans: Smart Strategy or Risky Move?

Understanding interest-only loans

Interest-only loans allow borrowers to pay only the interest portion of their mortgage for a specified period, typically 1-5 years. During this period, the principal loan balance remains unchanged, resulting in lower monthly repayments but no reduction in the amount owed.

How interest-only periods work

During the interest-only period, your repayments cover only the interest charges on your loan. At the end of this period, the loan automatically converts to principal and interest repayments, which will be higher than the original interest-only payments.

• Lower initial repayments during interest-only period
• Principal loan balance remains unchanged throughout period
• Significantly higher repayments when converting to principal and interest
• Interest-only period can sometimes be renewed (subject to lender approval)
• Total loan term may be extended to manage payment increases

Who benefits from interest-only loans?

Interest-only loans can be beneficial for specific borrower types and situations, but they're not suitable for everyone and require careful financial planning.

• Property investors seeking maximum tax deductions and cash flow
• Borrowers expecting significant income increases in coming years
• Those with temporary cash flow constraints but stable long-term prospects
• Renovators planning to sell quickly after improvements completed
• Borrowers with offset accounts to reduce interest while maintaining flexibility

Advantages for suitable borrowers

When used strategically, interest-only loans can provide financial benefits, particularly for investment purposes where tax considerations and cash flow management are important factors.

• Improved short-term cash flow for other investments or expenses
• Maximum tax deductibility for investment property interest payments
• Flexibility during income transition periods or major life changes
• Ability to pay principal voluntarily when circumstances improve
• Can help manage multiple financial commitments simultaneously

Disadvantages and risks

Interest-only loans carry significant risks that borrowers must understand and plan for, particularly the payment shock when the interest-only period ends.

• No automatic equity building through principal repayments
• Higher total interest costs over loan lifetime
• Significant payment increase when reverting to principal and interest
• Stricter lending criteria and ongoing serviceability assessments
• Potential negative equity risk if property values decline

Investment strategy applications

For property investors, interest-only loans can form part of a broader investment strategy focused on tax efficiency and portfolio growth.

Rental income ideally covers interest payments while allowing capital growth to build equity. All interest payments are fully tax-deductible, and surplus funds can be invested in additional properties or other assets.

Exit strategies and planning

Successful use of interest-only loans requires clear planning for the end of the interest-only period and strategies to manage the transition to higher repayments.

• Refinance to extend interest-only period with same or different lender
• Switch to principal and interest repayments when income increases
• Sell property before interest-only period ends
• Make voluntary principal payments during interest-only period to reduce future payment shock