Pros & Cons of Interest-only Loans

March 19, 2021

Interest-only home loan is an attractive choice when considering finance options. The prospect of lower repayments for a period of time to free up cash for other purposes might be appealing. But it’s worth bearing in mind, that this setup can have drawbacks, most notably the potentially greater long-term cost compared to other options. If you’re considering an interest-only home loan, let us explain how they work and what pros and cons you may want to think about before deciding.

An interest-only (IO) home loan is a lending arrangement where you only repay the interest on the amount you have borrowed for a set period of time. You pay nothing of the actual amount borrowed, so it doesn't reduce. Monthly payments for interest-only loans tend to be lower than payments for standard loans. That’s because standard loans typically include interest costs plus some portion of the loan amount.

So, lets look at the pros first

Lower regular payments

Because you are paying only the interest component on your home loan, your regular repayment will be comparatively lower during that period, before reverting to a higher regular principal and interest repayment amount. If you experience a reduction in income or go through a period of financial hardship for another reason, temporarily switching your loan repayments to interest-only could help make your loan repayments more manageable.

Free up cash

Having lower repayments during the interest-only period could be helpful if you need spare cash for other purposes. In addition, the money not being spent on paying down the loan’s principal could be used to pursue other investment opportunities such as a business.

Budget better

Sometimes an interest-only payment is the only payment you can afford. Interest-only loans offer an alternative to paying rent, which can be expensive and uncertain. If you have irregular income, an interest-only loan can be a good way to manage expenses. You can keep monthly obligations low and make large lump-sum payments to reduce the principal when you have extra funds.

Now the cons of interest only loans

More expensive in the long run

You end up paying more in interest over the life of your loan than you would with a principal and interest loan. This is because the interest rates available are generally higher. Another reason is that even without a difference in interest rate, you are not paying down the principal loan amount and are charged interest on the full loan amount throughout the interest-only period.

Less equity in your property

Equity is the difference between what your home is worth and the amount you owe on your mortgage.During the interest-only period, because you’re not paying back any of the loan’s principal, you are not increasing your equity in the property. In other words, the amount of the property that you own stays the same.

Your repayments will eventually go up

When your interest-only period comes to an end, your repayments will increase as you begin to repay the principal of the loan as well. This may come as a shock, particularly if your circumstances have changed since you took out the loan.

Of course there are ways to not be caught off guard when the interest-only term ends. In the lead up to transitioning to higher principal and interest repayments, you could gradually increase your loan repayments so that there is less of a shock when you eventually have to cover the full regular amount. You could also shop around for a lower interest rate as the interest rates on offer from different lenders may also have changed during your interest-only period, so it could be beneficial to take another look at what’s on offer. Alternatively, you may be able to negotiate an extension or another solution with your lender if your circumstances mean the increased repayments are going to be challenging.

All in all you should remember that interest-only loans are temporary. An interest-only loan keeps monthly payments low for a few years, but it doesn't eliminate the need to eventually pay back the full loan.

Reach out to us at Euphoria Loans if you would like to explore finance options, be it for an investment or to explore other options that are out there.