Interest-Only Home Loan Rates

To find the best interest-only home loan rates, you’ll generally need to look outside the major banks (ANZ, Commbank, NAB and Westpac) and instead focus on non-bank lenders and smaller banks and customer-owned lenders. These may be lenders you’ve never heard of (think Bank of us and P&N Bank), but borrowers who you’re willing to shop far and wide for the best home loan rates generally find them.

An interest-only home loan means lower repayments for a period of time, because the payments only need to cover the interest charged on the loan. Lenders offer this as an option for borrowers who need to free up cash for another purpose. The interest rate can either be fixed or variable, but a fixed rate home loan is more common.

The interest-only period is usually at the start of the loan term, but it can also be possible to switch over to interest-only repayments during the loan term (fees may apply).

If you choose interest only repayments, your repayments will be lower than they would have been if you were making principal and interest repayments. But once the interest-free period ends, the repayment will be higher than they would be under a standard principal and interest loan set up.

Let’s take the example of a hypothetical couple, Sue and Greg, who have a home loan on an owner-occupier property and are purchasing an investment property with a second loan. For the investment they opt for a 10-year interest-only term.

On a $750,000 home loan at 6.50% p.a. interest, their monthly repayments will be $678 lower than they would have been with principal and interest repayments. The lower investment loan repayments mean they have enough to cover the property management fees on their investment property and pay extra on their owner occupier loan.

They plan to hold the investment property and assess whether to sell it in 10 years at the end of the interest-only period, or hold it and revert to the higher principal and interest repayments on the loan. At that stage, they also plan to have their owner occupier loan cleared, freeing up cash to direct to the investment loan.

This is an entirely hypothetical and greatly simplified example. If you’re considering an investment-only home loan and/or purchasing an investment property, you should seek professional financial and mortgage advice before progressing.

Interest rates are generally higher on interest-only loans versus principal and interest loans. But how much of a difference there is will generally depend on whether you’re an investor or an owner occupier, with the gap generally being greater for owner occupiers.

Looking at the average mortgage rates in Australia, the average new investment home loan with interest-only repayments is 5.77% p.a. versus 5.59% for principal and interest loans. For owner occupiers, the average new interest-only loan has a rate of 6.36% p.a. versus 5.42% p.a. for principal and interest loans.

The reason the gap between rates are on investment loans compared to largely comes down to risk perception. For investors, an interest-only loan is generally seen as a common and often shrewd borrowing strategy. Whereas for owner-occupied loans, making interest-only repayments is sometimes associated with affordability challenges and potential risk for the lender after the interest-only period.

The reason the overall interest costs are generally higher with an interest-only loan is pretty simple: you’re being charged interest on a higher loan balance for longer because the balance is not being reduced at all while you’re only paying off the interest.

With a standard loan, you are gradually chipping away at the amount you borrowed, meaning each time interest is calculated on the loan, it’s based on a slightly lower amount.

An interest-only loan can be a great fit for borrowers in certain situations, but it won’t make sense for everyone. To summarise what we’ve covered so far, here are the three main pros and cons of an interest only loan.

Pros of an interest-only home loan

• Reduces your regular repayments during the interest-only period

• Offers flexibility to use spare cash in other ways

• You have the flexibility to choose the fixed-term duration

Cons of an interest-only home loan

• Interest-only home loan rates are usually higher than standard loans

• You’ll pay more interest overall with an interest-only loan

• The transition from interest-only to the higher principal and interest repayments can be a challenge

The default option at the end of your interest-only period will be simply to switch on to principal and interest repayments with the same loan. This will mean substantially higher repayments, so you need to be prepared. It’s worth considering gradually increasing your repayments before the loan transitions across, so it’s not as much of a financial shock.

Extend the interest-only term

In some situations, you may have the option to renew or extend the interest-only period on your loan when the initial term ends. Some loans have an overall maximum for how long repayments can be interest only, meaning you could use up part of the interest-only cap initially and then a further period later on if needed.

Refinance the loan

What a lot of borrowers do is switch or restructure their loan when the interest-only term ends. This is often a way of trying to find a lower interest rate to lessen the impact of the increase in repayments felt when the IO period ends. It’s generally a good idea to refinance your loan every few years anyway to make sure you’re still on a competitive rate.