When you take out a loan with a lender, the lender will calculate the loan repayment based on the term of the loan (how many years you have taken the loan out over) and the interest rate. The monthly payment will be calculated to ensure the principle (the amount you borrow) plus the agreed interest is fully paid.
In some cases, you may be able to make interest-only repayments for a specific period of time, but before you choose that option you need consider your financial situation as once the period ends, and you are switched to principal and interest repayments, the monthly loan repayment will be higher.
- Principal = the amount you borrow
- Interest = the amount you’re charged by the lender for borrowing the principal
Interest-Only Home Loans
During the interest only period (which may be two to five years), you pay ONLY the monthly interest that accrues on your loan. Therefore, the principal amount you borrowed does not reduce and interest continues to be calculated on this amount throughout this period. This means you end up paying more interest over the life of the loan.
Whilst the monthly repayment is lower during the interest-only, when the repayments revert to principal and interest, the monthly payment will be higher because the term left on your loan is now less, which means there is less time to pay down the principal amount.
Interest-only repayments may suit investors because of associated tax benefits; however, we recommend you speak to your accountant or financial adviser to determine if this is suitable for you. It is not normally a suitable strategy for owner occupied homes.
Example
John and Sarah have a loan of $500,000 and are deciding whether to pay interest-only repayments for the first five years of their home loan. The below table shows they will pay an additional 24,207 in interest over the life of their loan if they pay interest only for the first five years.
| Principal and interest for the life of a loan | Interest-only for the first five years | |
|---|---|---|
| Interest rate | 2.50% | 2.50%* |
| Loan size | $500,000 | $500,000 |
| Loan term | 30 years | 30 years |
| Monthly repayments during interest-only period | N/A | $1,042 |
| Monthly principal and interest repayments | $1,976 | $2,243** |
| Total interest payable | $211,218 | $235,425 |
** Principal and interest payments calculated on the remaining loan term of 25 years (30 total loan term less the first five years interest only).
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The information contained in this article is intended to be of a general nature only and has not taken into account any person’s objectives, financial situation or needs. We recommend you seek independent legal, financial and taxation advice.