Interest Only Home Loans — Lower Repayments

How Interest-Only Repayments Work

With a standard principal and interest (P&I) home loan, each monthly repayment covers both the interest accrued during the month and a portion of the principal balance. Over time, the principal component increases while the interest component decreases, gradually paying down the loan to zero over the full term.

An interest-only loan removes the principal component from your repayments for a set period. You pay only the interest that accrues each month, which means your repayments are lower but your loan balance does not decrease. At the end of the interest-only period — typically 1-5 years — the loan reverts to P&I repayments over the remaining term.

The repayment difference is significant. On a $600,000 loan at 6.29% over 30 years, P&I repayments are approximately $3,714 per month, while interest-only repayments are approximately $3,145 per month. That saving of $569 per month represents $6,828 per year in freed-up cash flow — money that can be directed toward other investments, used to pay down non-deductible personal debt, or held as a financial buffer.

Interest-Only as an Investor Strategy

Interest-only loans are most commonly used by property investors, and for good reason. The strategy aligns with two key principles of property investing: maximising tax deductions and optimising cash flow.

From a tax perspective, the entire interest payment on an investment property is tax-deductible. With an interest-only loan, the full monthly payment remains deductible for the entire interest-only period. With a P&I loan, the deductible interest component shrinks each month as the principal reduces. For an investor in the 37% tax bracket, the additional deductible interest on a $600,000 interest-only loan compared to P&I could save approximately $2,500 per year in tax.

From a cash flow perspective, lower repayments mean your investment property is cheaper to hold each month. If the property is negatively geared (expenses exceed rental income), the reduced repayments narrow the gap, reducing the amount you need to contribute from your own pocket each month. This can be the difference between being able to hold the property comfortably and being under financial stress.

The strategic investor uses the cash flow savings from interest-only repayments productively. Rather than letting the savings sit idle, they might direct those funds toward paying down their owner-occupied mortgage (which is not tax-deductible), building an emergency fund, or investing in additional properties or other asset classes to diversify their portfolio.

The Transition from Interest-Only to Principal and Interest

The most critical aspect of an interest-only loan is understanding — and preparing for — the transition to principal and interest repayments. When the IO period ends, your repayments increase because you now need to repay the full principal over a shorter remaining term.

Consider a $600,000 loan over 30 years with a 5-year interest-only period at 6.29%. During the IO period, repayments are approximately $3,145 per month. When the IO period ends, the $600,000 principal must be repaid over the remaining 25 years. The new P&I repayment would be approximately $4,017 per month — an increase of $872 per month or $10,464 per year. This is often called "payment shock" and catches some borrowers off guard.

To mitigate this, you should plan for the transition from the outset. Options include extending the IO period (if the lender agrees and your circumstances support it), refinancing to a new loan with a fresh 30-year term to spread the repayments, making voluntary extra repayments during the IO period to reduce the principal before the transition, or selling or refinancing the property if it has appreciated sufficiently.

When Interest-Only Makes Sense for Owner-Occupiers

While interest-only is predominantly an investor tool, there are legitimate situations where owner-occupiers benefit from IO repayments. Lenders will assess each application individually and must be satisfied that the arrangement is not unsuitable for the borrower.

Common scenarios where owner-occupied IO is appropriate include temporary income reduction (such as parental leave or a career transition), when a salary increase or windfall is expected within the IO period, when renovating a property and needing to manage cash flow alongside renovation costs, and when bridging between selling one property and settling on another.

APRA guidelines require lenders to scrutinise owner-occupied IO applications more carefully than investment IO. You will need to demonstrate a clear rationale for why IO is appropriate, and lenders will assess your ability to service the loan at P&I repayments at the end of the IO period. Having a well-articulated reason and a plan for the transition strengthens your application significantly.