The Drawbacks of Interest-Only Home Loans

The Drawbacks of Interest-Only Home Loans

An interest-only home loan leads to lower monthly payments. That’s only a short-term view, though. You’ll still have to handle the principal sum at some point. Know what you’re stepping into or an interest-only loan could come back to bite you.
Alexi Neocleous
Alexi Neocleous

Is Saving Money Now Worth Losing Money in the Future?

You have several options available to you when you start looking at home loan products. Beyond choosing between variable and fixed rates loans, you also need to look at the type of repayments. Most lenders offer the option between principal and interest (P&I) and interest-only loans.
Making interest-only payments on a home loan lowers your monthly outgoings considerably.

Let’s say you have a home loan of $320,000 at 6% interest. With the interest-only option, you pay just under $370 per week. Adding a principal payment on top can up that weekly figure by over $100.

That makes interest-only payments sound good at first. However, these loans can cause issues later on. Here we will look at five of the major drawbacks of interest-only home loans.

Drawback #1 – The Principal

Your home loan has a principal sum. This is usually between 80% and 100% of the value of your property. As you pay off the principal, the amount of interest you pay alongside it decreases.

This does not happen with an interest-only loan. Instead, all you pay is interest, which fluctuates depending on current rates. You also don’t pay any of the principal.

Once the loan ends, you are still left with the full principal to pay off, despite having spent thousands of dollars on the loan.

Drawback #2 – No Equity

Failing to pay any of the principal also means you have no equity in your home unless the market price of the house increases. In essence, the lender owns just as much of the home at the end of the loan as they did at the beginning.

Having no equity restricts how you borrow against the property. For example, consider your situation if you enter maternity leave. If you have no savings, you could have relied on the equity you’d built in your home to make payments.

With an interest-only loan, you don’t have access to such options. This means you limit the home loan products you can apply for.

Drawback #3 – Depreciation

It is possible for your property to decrease in value during the course of your loan. The term for this is depreciation.

Depreciation can come back to haunt you once an interest-only loan ends. You may find that your home is now worth less than it was when you took out the loan. This means that selling the property will no longer cover the principal.

As such, you may have to sell your home and then raise more money to pay the difference.

Drawback #4 – The False Sense of Security

The lower payments of an interest-only loan could lull you into a false sense of security. You may think you have more money to spend. In reality, the money you save in weekly payments should go aside for the costs you will face later.

Unfortunately, some borrowers don’t save properly. This could leave them unable to repay the home loan’s principal once the interest-only period ends.

A drastic fall in living standards often follows, sometimes requiring you to sell your house.

Drawback #5 – No Fixed Rate

Let’s say you see an interest-only home loan as a short-term solution. This is generally the case for owner-occupiers. You may feel you can take advantage of the lower payments for a while before switching to a loan that allows you to pay the principal.

The drawback here is that most lenders don’t offer fixed rates on interest-only loans. This means if interest rates increase, so do your weekly payments.

In extreme cases, this can make an interest-only loan more costly than a fixed rate P&I loan.

The Final Word

The information in this article is general in nature. An interest-only loan could work for you in the right circumstances. Always speak to a financial advisor or mortgage broker before making a decision.

If you have an investment property you can work out whether an interest-only loan is costing you more money than a principal and interest loan would using this investment property calculator.

This information in this article is general only and does not take into account your individual circumstances. It should not be relied upon to make any financial decisions. UNO can’t make a recommendation until we complete an assessment of your requirements and objectives and your financial position. Interest rates, and other product information included in this article, are subject to change at any time at the complete discretion of each lender.

Alexi Neocleous
Alexi Neocleous