While most home loans are principal and interest loans, there is also the option of paying back the interest component only.

With an interest only loan, you are not paying down any of the debt, however, you can significantly reduce your weekly repayments.

Advantages of interest only loans

The main reason to choose an interest only loan is that it lowers the weekly repayments you will be required to make.

interest-only 

An interest only loan is a good option for home buyers who need to keep their repayments as low as possible, because of either budget constraints or not wanting to tie up additional money each week.

Example:

A principal and interest loan of $400,000 at an interest rate of 4% would mean your minimum weekly repayment would be around $440 per week.

A $400,000 interest only loan with the same interest rate would be approximately $335.

You could potentially save $100 per week on your repayments; however, you will only be paying back the interest and not the debt itself.

Disadvantages of interest only loans

Because you are electing to pay back only interest, the actual interest rate on your home loan might be slightly higher than the comparable principal and interest loan. That is because an interest only loan represents more risk to the bank. However, interest rates are constantly changing as are loans, so that is not always the case.

Interest only loan terms are also typically 4-5 years. After the interest only period runs out, it will revert to a principal and interest loan, which means your repayments will rise at that time, unless you look to refinance and take out another interest-only loan.

If you choose an interest only loan, you could well find yourself paying back more interest over the life of the loan, because you are not reducing the principal in the early stages of the loan. This is something you need to weigh up against the fact that you will have additional cash in the first few years because of the lower repayments.

It is important to note that interest only loans are normally only available for investors and most lenders require owner-occupiers to pay back both principal and interest.

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