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What is an interest-only mortgage?

As its name suggests, an interest-only mortgage means your regular weekly, fortnightly or monthly repayments only include the interest charged. So you don’t repay any of the money you borrowed (known as the principal) until the end.

The agreed length, or term, of an interest-only loan is usually a year or two, but it can be up to five. After that, you have to repay the entire original amount of the loan. This could be done by switching to another loan, which is usually a principal-plus-interest mortgage.

Interest-only mortgages come with a degree of risk, so be sure to get some sound financial advice before you sign up for one. Here’s some general information to help you get started.

Should I get an interest-only mortgage?

For most people, the answer is usually no. While an interest-only mortgage will reduce your borrowing costs in the short term, you end up paying more overall. That’s because you keep paying interest on the full amount you borrowed.

Interest-only mortgages can, however, be useful for some investors. They’re also sometimes used by people who want to free up cash for the first year or two, to cover their initial purchase costs or urgent improvements. Another use is for short-term bridging finance, which is when you need to pay for a new home before you get paid for your old one.

Interest-only mortgages for investors

For many property investors or renovating builders, any interest paid on the mortgage for a property is a legitimate business expense for tax purposes. That means the interest paid effectively reduces the overall income earned from the property, so less income tax is due. For this reason, an investor may be happy with the higher overall cost of an interest-only mortgage, especially if it frees up money for renovations that add value to the property.

Interest-only mortgage while paying for purchase expenses

First home buyers are usually on a tight budget. The initial costs of buying a home can include registered valuations, legal fees, insurance, council rates and moving costs, as well as some essential appliances or furniture. This can reduce the amount available to cover home loan repayments in the short term. Although the interest-only mortgage costs more in the long run, it may provide extra certainty until things settle down. However, first home buyers need to be sure they can afford the higher regular repayments that will come when the interest-only term ends.

Interest-only mortgage for planned renovations

Finding a completely suitable home can be a challenge. Sometimes you find one that just needs some work to make it suitable for your family’s needs or to prevent further deterioration. An interest-only mortgage for the first year or two might make this work affordable, so you can complete repairs and improvements. After that you can switch to a regular principal-plus-interest mortgage. The purchase price, and so the amount you have to borrow, may also be less than it would for a home that doesn’t need any work.

Interest-only mortgage during temporary financial difficulty

Even with the best financial planning, which includes allowing for unexpected events, sometimes things can still take you by surprise. If you have a mortgage and are experiencing financial difficulties, it pays to talk with your lender sooner rather than later. They’ll be able to offer experienced practical advice, which might include different mortgage options. These could involve extending the term of your loan to reduce your regular principal repayments or switching to another type of mortgage. If your lender is confident your finances will return to normal in a year or two, one of the options might be a short-term interest-only mortgage to help see you through.

Interest-only mortgage until your income rises

If you’re not far away from a highly-likely increase in income, an interest-only mortgage may allow you to buy a more permanent home a year or two ahead of time. This sometimes benefits first-home buyers, particularly those starting out with secure promotion prospects or a guaranteed future financial windfall.

The disadvantages of an interest-only mortgage

There are several reasons why most people avoid interest-only home loans and prefer to repay the amount they borrowed as quickly as possible. Here are some examples:

  • As mentioned above, an interest-only mortgage costs more overall
  • When the interest-only term runs out, your regular repayments will increase substantially (to include principal) and you may not be able to afford them
  • You’re not repaying the money you borrowed to build equity in your home, which usually means having a smaller deposit for your next property
    When interest rates increase, your repayments could become unaffordable if you haven’t been reducing the amount you owe
  • House prices fall sometimes; if they drop substantially you could end up owing more than your home is worth

If the lenders won’t give you an interest-only mortgage

As tempting as an interest-only mortgage may seem, if the banks and other reputable lenders are saying “no”, they’re probably sparing you a whole lot of stress and possible financial embarrassment. They’re simply saying the risk of things going wrong is too high, even though they’d make more money from you in the long run on an interest-only mortgage.
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