For many Australians, a mortgage is one of the most significant financial decisions they will ever make.
Many people buying a house or refinancing their mortgage consider taking out an interest-only loan. A recent ASIC report (ASIC REP 445 Review of interest-only home loans released on 20 August 2015) found interest-only loans accounted for around 42% of all new home loans issued in the March 2015 quarter.
It is important to understand the risks of these loans, and to think carefully about whether an interest-only loan will be the best option for you in the long run.
Most home loans are principal-and-interest loans, which means your regular payments reduce the principal as well as paying off the interest.
With an interest-only loan, you only pay off the interest on the amount you have borrowed, for an agreed period – usually up to 5 years. During that time you do not repay any principal. At the end of the agreed time, the loan reverts to a principal-and-interest loan and you then start repaying principal as well as interest.
Interest-only loans may seem more affordable because their repayments are initially lower, but they cost much more in the long run. During the interest-only period, you do not reduce the amount of money you owe, so you pay more interest over the life of the loan; and you have to manage higher repayments when the interest-only period ends.
After you start repaying the principal, you’ll have less time to do it in. For example, if you take out a 30-year loan with a 5-year interest-only period, you will only have 25 years to pay back the principal, and your repayments will be much higher.
If your property does not increase in value during the interest-only period, you risk having no equity in your home at the end of this period, despite making payments every month. This can be risky if there is a downturn in the market or your circumstances change and you have to sell the house.
Some people make extra payments into an offset account to reduce the interest they pay on their home loan. This is a good strategy with an interest-only loan, but will only work if you can keep making these extra repayments without making any withdrawals. If you need to dip into your offset account, you might be better off with a principal-and-interest loan instead.
If you’re considering an interest-only loan, think carefully about whether:
Use ASIC’s MoneySmart interest-only mortgage calculator to find out what the loan will really cost you; and make sure you have a clear plan of action for when the interest-only period ends.
ASIC’s MoneySmart website provides impartial guidance and online tools to help you manage your money.
Australian Securities and Investments Commission