Insights for borrowers: Understanding interest-only loans

Interest-only loans can be a good option for borrowers needing assistance with cash flow, or sometimes as an investment strategy.

What are interest-only loans and how do they work?

To explain how an interest-only loan works, it’s important to clarify how a 'normal' - or principal and interest - loan works.

For any loan, the amount initially borrowed is referred to as the principal. An annual interest rate is usually charged on a monthly basis, in addition to any applicable fees.

Loan repayments - whether made weekly, fortnightly or monthly - cover the interest charged plus a small amount to reduce the principal balance. Over time, these repayments reduce the loan amount owed.

For an interest-only loan, as the name implies, repayments only cover the interest charged on the loan. This means they do not reduce the principal owed, so repayment amounts will be lower.

Generally, these loans will have a one to ten year interest only period, after which repayments will include both principal and interest. An alternative is to refinance the loan at this point and seek an additional interest-only period with another lender.

Why would you seek an interest-only loan?

There are a number of reasons why someone might apply for an interest-only loan. Generally, it is to assist with cash flow, but sometimes it’s an investment strategy. 

A common example is a loan obtained to construct a new home. During construction, repayments are usually on interest-only terms, to allow the borrower to afford to continue to pay rent or an existing mortgage while waiting for the construction to be completed.

Another example may be the purchase of a commercial property. A business might choose to purchase premises as it could be a lower cost than paying rent on their existing property but need their immediate cash flow to take on a new contract, expand or buy inventory. Seeking a one or two year interest-only term may provide the business the time it needs to increase turnover while retaining its cash flow, and then revert to making principal and interest repayments.

The pros and cons of interest-only loans

The pros and cons of interest-only loans very much depend on your particular circumstances. In general terms, however, there are a few points that are worth considering:

  • At the time of writing, rates on interest-only loans are slightly higher (on average 0.30 per cent per annum higher) than principal and interest loans
  • Repayments are lower as only interest is being paid. Taking advantage of lower repayments during the interest-only period may assist in  paying off more expensive debts, and/or making investments to build net worth
  • Unless the property value increases, no equity is built while making interest-only payments, as the principal amount owed is not decreasing. Should property prices fall, the loan amount owed may be more than the property is worth
  • Once the interest-only period expires, borrowers may experience ‘repayment shock’ as repayments increase to cover both principal and interest
  • Over the life of the loan, you will generally end up paying more interest, which is charged on the outstanding principal amount – this amount is not reduced for as long as you are only repaying interest.

To find out more about interest-only loans and whether they might be the right option for you, please get in touch with one of our Finance Solutions team.

Matthew Laming is an authorised credit representative 478711 of BLSSA Pty Ltd (ACN 117 651 760) Australian Credit Licence 391237. BDO Finance Solutions (SA) Pty Ltd Corporate Credit Representative Number 478582. Aggregation services provided by Choice Aggregation Services. © 2022 BDO Finance Solutions (SA) Pty Ltd. All rights reserved. Your full financial needs and requirements need to be assessed prior to any offer or acceptance of a loan product.