Is an interest-only home loan right for you?

/ personal finance

Interest-only mortgages have a number of pros and cons.

Australians are currently enjoying a period of record-low interest rates, with the Reserve Bank of Australia (RBA) reducing the base cash rate by a further 25 basis points in August to 1.5 per cent1.

The interest rate sets how much central banks charge other financial institutions for borrowing money, which in turn affects the interest rate on consumer loans2. A reduction in the base rate often means banks pass on lower charges to their customers.

Approximately 25 per cent of owner-occupier mortgages in the country are interest-only3.

An interest-only mortgage, as the name suggests, is when you take out a home loan that requires you to pay back only the interest for a certain period of time. Nothing is paid off the principal amount until a specified date, at which point the borrower is expected to clear the remaining amount owed.

Figures from the Australian Securities and Investments Commission (ASIC) reveal that approximately 25 per cent of owner-occupier mortgages in the country are interest-only, while two-thirds of investment property owners use this type of loan3

But what are the pros and cons of these mortgages? And which one is better for your credit file and your current financial circumstances? Let's delve into these products a little deeper and see whether they're the right option for you.

The advantages and disadvantages of interest-only loans

As we can see from the ASIC figures, interest-only mortgages are particularly popular with investors. This may be because the monthly home loan repayments are smaller and interest on a mortgage can be tax deductible4.

Investors can therefore maximise their tax deductions and then sell the property at the end of the mortgage term to repay the principal, provide the property has appreciated in value4.

Both homeowners and investors can use interest-only mortgages to reduce monthly outgoings and redirect the money into other ventures. However, there are downsides to taking the interest-only approach.

Canstar data shows that around 10 per cent of home loans don't have an interest-only option, so availability can be a problem4. You'll also need to pay off the principal once the interest-only term ends, and this could prove problematic if you don't have a plan for repayment or if the home has since lost value. 

Interest-only mortgages and personal finance. Interest-only mortgages have more affordable repayments than other home loans.

You may also want to consider how you're spending the extra cash you've freed up through an interest-only loan. For example, you may prefer to use the money to pay down debts with higher interest rates to improve your credit rating rather than buying luxury items or paying for holidays. 

It may also be worth considering overpaying on your mortgage while interest rates are low in order to protect against future RBA hikes and reduce the outstanding principal once the interest-only period ends. Before acting on any advice you should assess or seek advice on whether it is appropriate for your needs, financial situation and investment objectives.

1Reserve Bank of Australia, Cash Rate

2Bank of England, How does monetary policy work

3MoneySmart. Australia's interest-only mortgages

4Canstar. The Pros and Cons of an Interest Only Home Loan