An interest only (IO) loan is one that requires the borrower to repay only the interest charged each period, rather
than making repayments towards the principal and interest.
These types of loans are very popular with property investors, but they can be useful to owner/occupiers as well.
IO loan repayments will always be lower than standard principal and interest (P & I) loan repayments, because
you are only obliged to repay the interest component.
For example, if you have an IO loan of $200,000, you will only be required to pay the amount of interest charged
each month. If the home loan rate is 7%, this equates to $14,000 per year, or $1,165 per month.
This is far less than what you would be required to pay on a standard principal and interest loan, which a
mortgage calculator estimates would be around $1,415 per month. This equates to a saving of $250 each
month.
The pros
You can use this freed-up cash to help pay for other living expenses, or to boost your savings so you have a
cash buffer to help deal with emergencies.
But here’s the really good news: if the thought of making no progress on your loan makes you anxious, don’t
stress. You are free to make extra repayments as often as you like!
You could convert your mortgage to an IO loan and continue to make payments of $1415 per month – even
though you only need to pay $1,165.
That’s the main benefit of an interest only loan: your minimum obligation is lower, but you have the flexibility to
pay as much or as little off the principal amount as you wish.
This makes IO loans a great option for those who need some financial flexibility. For instance, you may be
experiencing a lower income cycle when you have small children and you’re not working.
In a few years time when the kids are at school, and your income improves because you’re once again earning a
regular income, you can transfer the loan back to a standard principal and interest product. But in the meantime,
you’re under less pressure when making your mortgage repayments each month.
The cons
Interest only loans are primarily aimed at property investors and as such, they are usually only available for
terms of up to five years. This is because the bank wants to see you make some headway with your outstanding
principal amount eventually, so they put a limit on the interest only time frame.
At the end of the interest only period your loan will generally revert to a standard principal and interest loan, with
repayments calculated over a 25-30 year time frame.
For those borrowers that are not very disciplined with spending and saving, they may find themselves five years
down the road without having made a single payment off their principal. The benefits of having lower mortgage
repayments throughout those five years may make it worthwhile, but this will depend on your personal situation.
As always, when making decisions to do with large sums of money, make sure you consult a trusted and
experienced mortgage broker or financial specialist to discuss your needs.
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