Pros and Cons of Interest-Only Loans in Today’s Market
Interest-only loans have long been a go-to strategy for certain borrowers, particularly property investors seeking cash flow flexibility or buyers managing short-term financial goals. But in today’s shifting economic climate — marked by rising interest rates, tighter lending rules, and a more cautious lending environment — the appeal and risks of these loans have become more complex.
For anyone considering this loan type, it’s crucial to understand how interest-only loans work, their advantages and disadvantages, and whether they’re a smart fit in the current Australian market.
In this guide, we break down the details of interest-only loans, highlight who they’re best suited for, and share tips to help you manage the risks wisely.
What Are Interest-Only Loans?
An interest-only loan is a type of mortgage where, for an agreed period — typically between one and five years — you pay only the interest on the loan, without repaying the principal.
Once this initial period ends, the loan usually switches to principal-and-interest repayments, which means you begin paying down the original loan balance along with ongoing interest. This transition can lead to a sharp jump in monthly repayments.
Example:
On a $500,000 loan at 6.0%:
- During the five-year interest-only period → monthly repayment = $2,500.
- After the period ends → monthly repayment increases to ~$3,500 to cover both principal and interest.
Pros of Interest-Only Loans
1. Lower Initial Repayments
Interest-only loans come with significantly lower monthly repayments during the interest-only phase, freeing up cash that can be used for other expenses or investments.
Example:
- Principal-and-interest loan of $400,000 at 6.0% = ~$2,398 per month.
- Interest-only loan = ~$2,000 per month.
Monthly saving: ~$398.
This can improve cash flow, especially helpful for first-time investors or borrowers with short-term financial goals.
2. Maximising Investment Potential
Interest-only loans are especially popular with property investors looking to:
- Fund multiple properties.
- Allocate funds toward renovations or improvements.
- Invest in other assets like shares or managed funds.
By reducing repayments, investors can stretch their capital further, potentially boosting their overall return on investment.
3. Tax Benefits for Investors
In Australia, interest on investment loans is tax-deductible. This means that investors using interest-only loans can maximise their deductible expenses during the early years of the investment.
Important note: This tax benefit does not apply to owner-occupiers.
4. Increased Financial Flexibility
Reduced repayments during the interest-only period provide more breathing room to:
- Build an emergency savings buffer.
- Pay off higher-interest debts like credit cards or personal loans.
- Save for major life events such as a wedding, a new baby, or travel.
5. Adaptability to Market Conditions
During times of economic uncertainty or fluctuating income (such as self-employment or contract work), interest-only loans offer flexibility by temporarily lowering repayment obligations.
Cons of Interest-Only Loans
1. Higher Long-Term Costs
While you save in the short term, the total cost over the life of the loan is typically higher because:
- You pay interest on the full loan amount for longer.
- You delay paying down the principal, which increases total interest costs.
Example:
- $400,000 loan at 6.0% over 30 years → total interest ~$463,000 (principal-and-interest).
- Five years interest-only → total interest ~$498,000.
Extra cost: ~$35,000.
2. Payment Shock After Interest-Only Period
Once the interest-only period ends, repayments can jump significantly.
Example:
$500,000 loan → monthly repayment jumps from ~$2,500 to ~$3,800 when transitioning to principal-and-interest, assuming the same rate.
If rates have increased in the meantime, the jump can be even steeper — potentially straining your household budget.
3. Risk of Negative Equity
Without paying down the principal, you’re more exposed to the risk of negative equity, where:
- Your loan balance > the value of your property.
- Selling or refinancing becomes much harder without incurring a loss.
This is especially concerning in a declining property market.
4. Limited Loan Features
Many interest-only loans come with:
- Fewer flexible features (such as offset accounts or redraw facilities).
- Restrictions on extra repayments.
- Stricter conditions around refinancing.
5. Stricter Lending Criteria
In recent years, lenders and regulators have tightened the rules around interest-only lending. Borrowers face:
- Higher interest rates compared to principal-and-interest loans.
- More rigorous credit checks.
- Lower maximum borrowing limits (often capped at ~80% LVR).
6. No Equity Build-Up
During the interest-only phase, you don’t build equity by reducing the loan balance. This limits your ability to:
- Refinance.
- Access additional funds.
- Leverage the property for future investment.
7. Potential Impact on Retirement Plans
For owner-occupiers, delaying principal repayment can leave you carrying a large mortgage into retirement — potentially compromising your financial security when your income drops.
Interest-Only Loans in Today’s Australian Market
Impact of Rising Interest Rates
With the Reserve Bank of Australia (RBA) steadily increasing the cash rate over recent years, interest-only borrowers on variable rates have seen repayments rise sharply.
Example:
A variable interest-only loan that started at 5.5% may now sit at 6.5%, adding ~$417 per month on a $500,000 loan.
This makes locking in fixed rates — or switching to principal-and-interest — an increasingly important consideration.
Regulatory Changes
Australian lenders are now required to assess your ability to repay a loan on a principal-and-interest basis, even if the loan is initially structured as interest-only. This makes qualifying for these loans more challenging and reduces the risk of borrowers overextending themselves.
Who Are Interest-Only Loans Best Suited For?
Property Investors
Investors who:
- Prioritise cash flow.
- Want to maximise tax deductions.
- Plan to sell or refinance before the interest-only period ends.
Borrowers With Short-Term Goals
Those who:
- Plan to sell the property soon.
- Expect a significant income increase.
- Need temporary repayment relief (such as during parental leave).
High-Income Borrowers
Well-capitalised borrowers who use the cash flow savings from an interest-only loan to invest in higher-return opportunities (such as shares or business ventures).
How to Minimise Risks
- Plan for the payment shock:
Use a loan calculator to estimate post-interest-only repayments and make sure you can comfortably afford them. - Build equity elsewhere:
Channel savings into other investments, offset accounts, or savings to strengthen your financial position. - Understand the terms:
Carefully review break fees, feature restrictions, and reversion rates. - Consult a mortgage broker:
Get expert advice to compare options and tailor your loan structure to your goals. - Monitor market conditions:
Stay informed about rate movements and property values to adjust your strategy proactively.
Final Thoughts: Should You Consider an Interest-Only Loan?
Interest-only loans can offer powerful short-term benefits — particularly for investors — but they’re not without significant risks.
For the right borrower, they can:
- Improve cash flow.
- Support investment strategies.
- Provide financial flexibility.
But without careful planning, they can also:
- Lead to higher long-term costs.
- Create refinancing challenges.
- Expose you to repayment shocks.
In today’s market, where rates are rising and lending conditions are tighter, it’s more important than ever to:
- Align your loan choice with your long-term goals.
- Run the numbers carefully.
- Seek expert guidance before committing.
