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The pros and cons of interest only loans

07 July 2015

What is an interest-only loan?

Normally, when you take up a home loan, you need to pay a portion of the principal and interest (P&I) every month. With interest-only loans, you only pay the interest component of the loan and not the principal component. These loans are usually 5 to 10 years interest-only, after which the bank will want you to pay off the principal.

During the term of the interest-only loan, your repayments will be lower and hence make it affordable for the first few years. Some examples of when interest-only loans are chosen over P&I loans.

a) You are currently on one income and your wife is on maternity leave. You know that once she goes back to work, you will have more cash flow. So, to make it easy on your cash flow, you may choose interest-only option for 3 – 5 years.

b) Another example is when investors are building their property portfolio and want to keep their borrowing capacity to the higher limit or make minimum repayments only, they may choose interest-only loans.

c) First home buyer who wants to get into the property market, can choose interest-only loans to make it easy with their repayments for a while.

Advantages of interest-only loans

  • Tax deductions: Investors are often advised to take up interest-only loans because the interest component is tax deductible and hence they just pay what they can claim. This can help them in two ways. One, if they want to increase their borrowing capacity a little bit to be able to borrow more, this can help. The second is that they can use the extra cash flow to reduce their non-taxable debts.
  • Lower repayments: For the term of the interest only loan (1 – 5 years normally), you will be making lower repayments than a P&I loan. This helps when you are under a tight budget, but know that your financial position will change in the near future.
  • First Home Buyers: As mentioned above, interest-only repayments help first home buyers to get their foot in the door sooner and hence get into the property market without being overwhelmed.

Disadvantages of interest-only loans

  • Not gaining any equity: When you repay only the interest portion, you don’t reduce the principal component and hence you will not gain any equity in the property until you are making principal-only repayments.

If you want to sell your property post interest-only term (be it 5 years or 10 years), your loan amount will not have gone down and you will be liable for the full loan amount back.

So basically, unless your property value has gone up during the interest-only term, you will not have any equity.

  • Higher repayments at the end of the interest-only term: Once the interest-only term finishes, you will be asked to make higher repayments.

Example: Let’s assume you took a 10 year interest-only repayment option. At the end of the 10 years, you will be asked to make principal and interest repayments over 20 years, which can be a large increase in your repayments. This can often catch you off-guard because you were not expecting it.

  • Affordability: You may be better off in the initial interest-only term, but if you don’t plan for the future, you may find yourself struggling to pay off the principal and interest afterwards. Also, the interest that you pay post IO period can be quite high.

Consider the pros and cons of any loan feature and make a decision that will suit your lifestyle. Always consult your accountant or lawyer for advice.