What Are Interest-Only Repayments?

March 2022 – 9 minute read

What you’ll learn

• What’s the difference between an interest-only and principal and interest loan?
• How do interest-only loans work?
• What are the benefits of interest-only repayments?
• Why would you choose an interest-only home loan?
• Are there potential tax benefits with interest-only repayments?
• How do I apply for interest-only repayments?

1.   What’s the difference between an interest-only and principal and interest loan?

When you secure a home loan from a bank or credit provider, you can choose to pay back the loan by selecting one of two different loan repayment options to suit your financial circumstances:

When you apply for a home loan, the lender will perform a credit assessment to confirm that you can repay the loan by factoring in principal and interest repayments. They do this because, at some stage, if you keep your mortgage, you’ll need to pay back the loan amount you’ve borrowed on top of the loan interest charges.

Will paying both principal and interest make a difference?

Yes. By paying principal and interest payments, you’ll pay off your home loan faster than if you were only paying the interest. As the interest you pay is calculated on the loan balance, the more principal you pay back, the faster you’ll pay off your loan.

There are other ways that you can also help reduce your loan balance and pay back your mortgage sooner:

• In addition to paying principal and interest, if you made your payments more frequently – weekly or fortnightly as opposed to monthly repayments
• Open an offset account or redraw facility to use your savings to offset the interest you’ll pay
• Make extra repayments above the required amount to repay your loan.

2.   How do interest-only loans work?

If you’ve decided that you’d like to make interest-only payments on your home loan, you’ll need to request with your lender an interest-only period. Most lenders have an interest-only period time limit, which means that depending on your loan type, you’ll only be able to make interest-only payments for a fixed number of years over the life of the home loan.

At Westpac, it depends on the type of home loan on the time limits that will apply:
 

What if I want to extend my interest-only period?

If you’ve reached the limit on the maximum allowable time on interest-only over the life of a loan, most lenders will not allow you to extend. However, you may be able to refinance your loan. It would be best to talk to your lender first, as refinancing with your current lender may be easier (as they already know you) than switching to another lender.

Can I pay interest-only repayments on a fixed interest home loan?

Yes. The type of home loan you have – variable or fixed rate interest home loan – doesn’t affect whether you can choose to make interest payments only. However, if you want an interest-only loan, you need to set that up before locking in your interest rate, as you can’t do it mid-term. Also, be mindful of the time limit condition for interest-only home loans. At Westpac, it's 5 years on an Owner-occupied home loan and 10 years on an Investor home loan.

Is Interest Only in Advance the same thing?

No. At Westpac, Interest Only in Advance is a repayment option open to investors with a Fixed Rate Investment loan. It provides an interest rate discount for paying the interest on the loan 12 months in advance. It also allows an investor to consolidate the interest repayment into one lump sum, potentially claiming a tax deduction on the prepaid interest for the coming financial year.

3.   What are the benefits of interest-only repayments?

An interest-only mortgage allows borrowers to reduce their repayments in time of need or may enable property investors, to claim tax benefits*, as the total interest repayment may be tax-deductible. If you need funds for an unexpected event or want to reduce financial stress for a period, you can do it for up to 5 years on an Owner-occupied home loan or up to 10 years on an Investor home loan. Interest-only could be a lifesaver in the short term, but you can also consider other options before committing to long periods without paying back your loan principal.

What else should I be aware of?

When your repayments are interest-only you need to be aware of some catches. These aren’t necessarily negative. They’re just points you need to be mindful of:

• Interest-only repayments are only available for a set period over the life of the loan
• When your interest-only term ends, your principal and interest repayments will be higher than if you’d been paying both the principal and interest from the start
• The equity in your property will build at a slower pace during the interest-only period
• By paying interest-only for a period over the life of your loan it means you’ll pay more interest than if you’d been paying both the principal and interest.

What happens if I can’t afford the repayments after my interest-only period ends?

If you’ve been paying interest-only on a home loan for an extended period, the increase can be a shock when switching to principal and interest. If you find you can’t afford the new repayments after 5 years or more of interest-only, you may need to refinance your loan. By refinancing your loan, you could potentially apply for a 30-year term, which would lower the principal and interest repayments. Of course, this would mean that as you’ve increased your loan term, the interest payable over the long run will be more. It’s advisable to always speak to your lender first as they’ll be able to provide you with the available options. Reviewing your home loan is also good practice as it means you’re ensuring your loan is working as hard as it can for you and meeting your personal and financial goals.

4.   Why would you choose an interest-only home loan?

Depending on your circumstances, there could be reasons why you would need an interest-only period. These could include:

If you want to see how much interest-only payments would be on your current loan, use our handy repayment calculator. It will also show you how changing repayment type, and frequency will affect how long your loan will take to pay off. 

Could having an interest-only home loan affect my ability to get a second mortgage?

If you’re applying for another home loan and your current mortgage is interest-only, it could affect your borrowing power. Lenders tend to access borrowing power for an interest-only home loan differently from calculating one with principal and interest repayments. The lender needs to ensure that when your interest-only period expires, you’ll be able to make the new higher principal and interest payments.

Does it make sense to set up an offset account with an interest-only home loan?

From an investment point of view, using an offset account to help reduce interest is a good strategy, as the lower the interest repayment, the better. You’ll need to be mindful that an offset account can only be used with a variable rate home loan. If you have a fixed rate loan, that strategy will not apply. However, you could look at making extra repayments instead.

Can I make extra repayments with an interest-only home loan?

Yes. Whether your home loan is on a fixed or variable rate, you can make extra repayments into the loan account. However, there will be a prepayment threshold for fixed rate loans, meaning a maximum amount you can make as extra repayments over the fixed rate period without incurring break costs. By making extra repayments, you’ll reduce the loan balance and minimise the remaining loan term and interest you’ll pay. You may also be able to redraw the money if you need access to the funds.

5.   Are there potential tax benefits with interest-only repayments?

If you have an Investor loan and you rent out your property, there are potential tax benefits* to making interest-only payments. You can generally claim tax deductions on interest paid to reduce your rental income, effectively reducing the tax payable. You can’t claim tax deductions for the personal or private use of a property. Some investors also like to take advantage of Interest Only in Advance, where the interest for the entire year is paid at once, which may allow a tax deduction claim on the prepaid interest.

Other benefits of interest-only repayments for property investors.

When you invest in property there are costs associated with owning a rental property. Apart from the initial outlay to purchase the property, these costs could involve:

• Investment loan repayments
• Fees and agent commissions
• Landlord and building insurance
• Costs of repairs and maintenance

Interest-only loans enable landlords to keep costs down, freeing up cash for further investment, while relying on the capital growth of their property. If the property market is strong and the value of your property increases, this could be a good strategy. However, if the value of the property decreases and you’ve only paid interest payments, and you need to sell, you could face a net loss.

How long do you intend to keep your investment property for?

Suppose you plan to keep your investment property long-term. You could give yourself more options by riding out property values and interest rates fluctuations, especially if you’ve used up all your interest-only period. However, suppose you plan on keeping your investment for a maximum of 5 years. In that case, you’ll need to carefully watch the market and what the Reserve Bank is doing with interest rates to ensure that capital growth is building your equity. If it’s not, you may need to switch from interest-only to principal and interest payments to ensure you’re staying ahead. With a variable rate home loan, switching between the repayment types will be easier than being on a fixed rate loan. With a fixed rate, you’ll need to wait for your fixed term to expire before you can switch. It’s important to consider market trends and movements before deciding on an interest-only period and whether to fix your interest rate or keep it variable.

6.   How do I apply for interest-only repayments?

If you’re after a new home loan, bridging or construction loan with interest-only repayments, you’ll need to complete a new home loan application. A lender or mortgage broker will access your ability to repay the loan considering the principal and interest repayments on the loan amount. You're unlikely to be approved if you can't afford the higher repayments.

What if I already have a home loan and want to switch to interest-only?

Changing from principal and interest repayments to interest-only does not simply involve a flick of a switch. Your lender will want to access your ability to repay the loan at the rate applicable for interest-only loans. Interest-only loans will generally have a higher interest rate than loans where you repay both principal and interest. It’s wise to speak to your lender about your options and ability to pay.
 

Will I pay the same interest rate if I switch to interest-only repayments?

No. Lending criteria for interest-only home loans differ from those where the borrower pays both an interest and principal amount. Interest rates tend to be higher for interest-only home loans.