Interest only mortgage

Definition

Interest only is not so much a particular mortgage type, but a repayment option. Although many lenders and some mortgage brokers will talk with you about a special interest only mortgage, the reality is that most quality loans, from basic home loans to the most flexible mortgage with all the bells and whistles will offer interest only as a feature. When you borrow money, there are three parts to the repayment of that loan:

Principle (the money that you originally borrowed)
Interest
Fees and Charges (most lenders bill these charges separate to each repayment)

Repayments based on interest only do not include a component of principle as they would for a more traditional principle and interest mortgage. This has a threefold effect.

Your minimum monthly repayments during the interest only period are lower.
You do not reduce your original mortgage balance unless you make extra repayments.
When you start repaying the mortgage, your repayments will be significantly higher.
You will pay more interest across the life of your loan, unless you make extra repayments.

Like many other mortgage features and types, an interest only mortgage comes from a commercial lending history and is now readily available for residential mortgage lending

Interest Only Terms (duration)

There are two types of interest only terms. The first is a limited interest only period, which is generally between 1 and 5 years, however some lenders will allow you to take an interest only repayment term for up to 10 years. Mortgages with a limited interest only period, usually revert to principle and interest automatically at the end of the interest only period. Some lenders will grant a further interest only period. However you should be mindful that the longer you take an interest only period, the shorter the period you will have to repay the principle. This can produce a dramatic increase in the minimum repayment.

The second type of interest only is an evergreen facility. This type of repayment remains interest only for the life of the loan, at the end of which, you will be required to repay the outstanding principle in a single balloon payment. The principle balloon is usually repaid by either refinancing or selling the property. This facility is most commonly offered as a line of credit mortgage.

Advantages

There is only one real advantage to an interest only repayment option. As the repayment is lower, it increases the amount of short term disposable cash you have for other purposes after making your monthly loan repayment.

Disadvantages

There are several disadvantages to interest only mortgages. The first and often most significant is that most people pay only the minimum repayment obligation. For these people, the amount owed does not reduce and the amount of interest paid as a result is significantly higher. People who are most likely to take out an interest only option are people with investment based debt who prefer to use money ordinarily dedicated to repaying principle, for some other purpose.

The second disadvantage is that at some stage the interest only option will end and you will be facing a shortened period to repay the principle, which may force you into refinancing your loan or selling your property.

Beware of

Mortgage brokers or lending consultants that suggest an interest only mortgage when you do not have any specific use for the extra short term disposable cash. As this type of mortgage delays the repayment of the principle, both lenders and mortgage brokers alike make more money than they do on a principle and interest loan.

Pricing

Interest only mortgages attract the same rate their principle and interest counterparts except in the case of a line of credit which can attract a rate loading of around 0.05% for some lenders. Lines of credit also have other limitations that may affect their suitability.

Popularity

In Australia interest only mortgages are generally less popular than principle and interest mortgages.