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1. What is an Interest-Only home loan?
An interest-only home loan is a type of loan where you only pay the interest on the loan for a certain period. You pay only the interest on the loan amount for a set number of years, for example, 5, 7, or 10 years.
During this period, you are not paying the principal balance of your home loan. Principal is the portion of the original loan amount, while interest is the cost of borrowing the money. After the interest-only period ends, you start a regular payment period that includes the actual balance and interest.
2. How does an Interest-Only loan differ from a Principal & Interest (P&I) loan?
The following are the differences between an interest-only loan and a principal & interest (P&I) loan:
Interest-Only Loan
You pay only the interest on the loan amount for a set period, but once this period is over, you will start paying the actual balance and interest. During the interest-only period, you are not paying the principal balance, and thus, there is no principal reduction on your loan.
Principal & Interest (P&I) Loan
In a P&I home loan, you pay both the principal amount and the interest from the start. Because of this, you are reducing the principal balance and gradually building equity in your property.
Although an interest-only loan may seem manageable, this may be temporary. Before considering this type of loan, assess your current and projected financial situation to determine if you can afford higher payments after the interest-only loan period expires.
Also, consider the possibility of home value appreciation or depreciation in your area, as these can significantly affect your payment amounts once the interest-only period is over.
3. What happens when the Interest-Only period ends?
After the specific interest-only period ends, you will pay both the principal loan amount and interest.
4. Are Interest-Only loans suitable for first-time home buyers?
Interest-only loans are generally not recommended for first home buyers because of the following reasons:
Lack or limited equity buildup: The biggest disadvantage of interest-only loans is the lack of equity buildup. This type of loan is similar to renting a property without a growing ownership stake.
Payment Shock: After the interest-only period is over, buyers usually experience a dramatic payment shock as they are forced to pay the principal loan amount plus interest. This can create severe strain on the home buyer’s finances.
Negative Equity: In case of declining home values, you could end up owing more on your mortgage than your home is worth. This leads to negative equity.
Limited predictability: In Australia, interest-only loans can have either fixed or variable interest rates. This means the interest rate and your payments can fluctuate, sometimes making budgeting challenging.
First home buyers may find traditional fixed rate mortgages more suitable for their needs. This type of loan is predictable as the monthly payments remain the same throughout the loan term. You also experience steady equity growth as you regularly pay the loan amount. Finally, you can enjoy improved financial stability with more predictable and manageable long-term budgeting.
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