Interest-only (IO) home loans allow you to pay only the interest portion for a set period (typically 1-5 years), without reducing the principal. This guide explains how IO loans work, who should use them, and the pros and cons.
What is an Interest-Only Home Loan?
Interest-only loans defer principal repayments for an initial period:
How it works:
- IO period: Pay interest only (1-5 years typically)
- After IO period: Converts to principal + interest
- Loan term: Usually 30 years total
Example $500,000 loan @ 6.5% p.a.:
Years 1-5 (Interest-Only):
- Monthly payment: $2,708
- Pays interest only
- Principal remains $500,000
Years 6-30 (Principal + Interest):
- Monthly payment: $3,398
- Pays down principal over remaining 25 years
- Higher payments as catching up
Interest-Only vs Principal & Interest
Side-by-side comparison:
$500,000 loan @ 6.5% p.a., 30 years
Interest-Only (5 years):
- Years 1-5: $2,708/month (IO)
- Years 6-30: $3,398/month (P&I on 25 years)
- Total interest: $679,000
- Loan balance year 5: $500,000
Principal + Interest (30 years):
- Years 1-30: $3,160/month
- Total interest: $637,000
- Loan balance year 5: $457,000
Difference:
- Save $452/month during IO period
- Pay $42,000 more interest over life
- Principal not reduced during IO
Interest-Only Loan Rates 2025
IO rates typically 0.1-0.5% higher:
Owner-Occupier:
- P&I rate: 6.0-6.5% p.a.
- IO rate: 6.3-7.0% p.a.
- Premium: +0.3-0.5% p.a.
Investment:
- P&I rate: 6.2-6.8% p.a.
- IO rate: 6.5-7.2% p.a.
- Premium: +0.3-0.4% p.a.
Why higher?
- Banks see higher risk
- No principal reduction = higher LVR over time
- APRA restrictions on IO lending
Who Uses Interest-Only Loans?
Property Investors (Primary Users)
80%+ of IO loans are for investment properties
Why investors choose IO: ✅ Lower monthly repayments ✅ Maximize tax deductions (interest fully deductible) ✅ Preserve cash for other investments ✅ Leverage strategy ✅ Plan to sell before IO period ends
Example investor:
- Investment property: $600,000
- IO payment @ 6.8%: $3,400/month
- P&I payment @ 6.5%: $3,950/month
- Save: $550/month ($6,600/year)
- Use savings: Build investment portfolio
Owner-Occupiers (Occasional Users)
Reasons owner-occupiers use IO:
- Expecting income increase soon
- Managing cash flow during career change
- Renovating property (will sell after)
- Short-term ownership plan (3-5 years)
- Offset account strategy
Less common because:
- Not building equity
- Higher rates
- No tax benefits (interest not deductible)
Benefits of Interest-Only Loans
1. Lower Monthly Repayments
Immediate cash flow relief:
$500,000 loan:
- IO @ 6.8%: $2,833/month
- P&I @ 6.5%: $3,160/month
- Save: $327/month ($3,924/year)
Use savings for:
- Other investments
- Emergency fund
- Lifestyle expenses
- Additional property deposits
2. Tax Efficiency (Investors)
Maximize tax deductions:
Investment property:
- Interest: 100% tax deductible
- Principal: Not deductible
Example:
- IO interest: $34,000/year (deductible)
- Tax saving @ 37% rate: $12,580/year
- P&I interest: $32,000, principal $6,000
- Tax saving: $11,840/year
- Extra deduction with IO: $740/year
3. Preserve Capital
Keep cash available:
- Don't tie up money in home equity
- Deploy capital to higher returns
- Maintain investment flexibility
- Build share portfolio instead
4. Leverage Strategy
Maintain high leverage:
- Loan stays at original amount
- Property (hopefully) appreciates
- Equity growth from capital gains, not principal reduction
- Can redraw equity for next investment
Example over 5 years:
- Loan: $500,000 (stays same with IO)
- Property value: $600,000 → $750,000
- Equity: $100,000 → $250,000
- Equity gain: $150,000 (from growth, not payments)
5. Flexibility
IO + Offset strategy:
- Make IO payments
- Park savings in offset account
- Reduce interest paid
- Access funds anytime
- Acts like P&I but with flexibility
Risks & Disadvantages
1. Payment Shock
When IO period ends:
$500,000 loan, 5yr IO @ 6.8%:
- Years 1-5: $2,833/month
- Year 6+: $3,455/month (25yr P&I)
- Increase: $622/month (22% jump)
Mitigation:
- Budget for increase
- Refinance to new IO
- Sell property
- Use offset to reduce principal
2. No Equity Building
Principal doesn't reduce:
- After 5 years IO, still owe $500,000
- Equity growth only from property appreciation
- If market flat, no equity gain
- LVR increases with falling market
Risk scenario:
- Bought: $600,000 (borrowed $540,000 at 90%)
- 5 years later: Worth $570,000 (market down 5%)
- Still owe: $540,000
- LVR now: 95% (vs 82% with P&I)
3. Higher Total Interest
Costs more over life:
$500,000, 30yr @ 6.5%:
- P&I entire 30yr: $637,000 interest
- 5yr IO then P&I: $679,000 interest
- Extra cost: $42,000
But investors compare:
- Extra interest: $42,000
- Less tax deductions: ($15,000)
- Could invest savings: +$50,000
- Net position: May still be ahead
4. Lender Restrictions
APRA limits IO lending:
- Banks cap IO loans at 30% of portfolio
- Tighter criteria than P&I
- Lower LVRs (usually 80% max)
- More serviceability scrutiny
- Harder to refinance IO repeatedly
5. Refinance Risk
What if you can't refinance?
- Forced to P&I at end of IO
- Property value fallen = can't refinance
- Interest rates risen = don't qualify
- Lender policy changed = no IO available
Mitigation:
- Keep LVR under 70%
- Maintain good serviceability
- Multiple lender options
- Start refinance process 6 months early
Interest-Only Investment Strategy
How sophisticated investors use IO:
The Strategy
Buy investment property
- Borrow 80% ($400k on $500k property)
- Interest-only loan
Rent covers most costs
- Rent: $450/week = $1,950/month
- IO payment: $2,267/month
- Shortfall: $317/month
Tax benefits reduce cost
- Interest deductible: $27,200/year
- Other deductions: $5,000/year
- Tax saving @ 37%: $11,914/year
- Net monthly cost: $-676/month
Preserve cash flow
- Save $400+/month vs P&I
- Build deposit for next property
After 5 years
- Property worth $620,000 (4% growth)
- Equity: $220,000
- Cash saved: $24,000
- Buy second investment property
Refinance to new IO
- Extend IO another 5 years
- Or sell if strategy changed
Why Investors Choose IO
Leverage maximization:
- Keep debt high
- Property growth on full value
- Not paying down "good debt"
Tax optimization:
- Maximize deductions
- Pay off non-deductible debt instead (PPOR)
- Interest-only on investment, P&I on home
Cash flow management:
- Lower payments = more properties
- Build portfolio faster
- Positive or neutral cash flow
Flexibility:
- Plan to sell before IO ends
- Not emotionally attached
- Business decision
IO + Offset Account Strategy
Best of both worlds:
How it works:
- Take IO loan
- Link 100% offset account
- Park extra cash in offset
- Pay interest only on net balance
Example:
- Loan: $500,000 @ 6.5% IO
- Offset balance: $100,000
- Interest charged on: $400,000
- Savings: $541/month
Benefits: ✅ Low mandatory payments (IO) ✅ Reduce interest (via offset) ✅ Access to cash (offset is liquid) ✅ Flexibility to deploy capital
Perfect for:
- Self-employed (irregular income)
- Investors building war chest
- Those wanting options
Example strategy:
- Mandatory payment: $2,708 (IO)
- Put $1,000/month extra in offset
- After 5 years: $60,000+ in offset
- Effective P&I but with full access
- Use $60k for next property deposit
When IO Makes Sense
Good Reasons to Use IO
✅ Investment property - Tax benefits, leverage ✅ Short holding period - Selling within 5 years ✅ Offset strategy - Parking cash with access ✅ Higher return elsewhere - Investing savings at >6.5% ✅ Cash flow priority - Need lower payments now ✅ Development/reno - Temporary low payment period ✅ Debt recycling - Converting non-deductible to deductible
Poor Reasons to Use IO
Can't afford P&I - Borrowing too much Hoping for price growth - Risky speculation Ignoring payment shock - Will struggle when IO ends No plan for refinance - Trapped when IO expires Owner-occupier with no offset - Just costs more
Interest-Only Eligibility
Lender requirements for IO:
Standard Criteria
Higher hurdles than P&I:
- LVR: Usually 80% max (vs 95% for P&I)
- Serviceability: Tested at P&I repayment level
- Credit score: Higher standards (680+ typical)
- Income: Stable, verifiable income
- Deposit: Larger (20%+ usual)
Investment vs Owner-Occupier
Investment properties:
- Easier to get IO approved
- Standard product for investors
- Rental income considered
- Clear tax benefit
Owner-occupiers:
- Much harder since 2017
- Need clear justification
- Many banks limit or decline
- Higher rates if approved
Loan-to-Value Ratios
Maximum LVR by lender:
- Major banks: 80% LVR IO
- Non-banks: 85-90% IO (some)
- 90%+ LVR: P&I usually required
Example:
- Property value: $600,000
- Maximum IO loan: $480,000 (80%)
- Need deposit: $120,000 (20%)
IO Loan Approval Process
What you'll need:
Standard documents: ✅ Proof of income (payslips/tax returns) ✅ Asset/liability statement ✅ Rental appraisal (investment) ✅ Property details/contract ✅ Identification ✅ Bank statements
Justification (owner-occupier):
- Why you need IO
- Plan for end of IO period
- Evidence of higher income coming
- Offset account strategy
Serviceability tested at:
- P&I repayment (not IO)
- Rate + 3% buffer
- Must prove can afford P&I
Refinancing IO Loans
When IO period ends:
Option 1: Revert to P&I
Simplest option:
- Loan converts automatically
- Higher repayments start
- No application needed
When to choose:
- Built up offset balance
- Income increased
- Nearly paid off
- Last property in portfolio
Option 2: Refinance to New IO
Extend IO period:
- Apply 6 months before IO ends
- New lender (or same lender)
- Another 5 years IO
- Reset the clock
Requirements:
- Property revalued
- LVR assessed (need 20%+ equity)
- Income still qualifies
- Lender willing to do IO
Costs:
- Application fees: $0-$800
- Valuation: $300-$800
- Discharge fee: $300-$500
- Potential break costs if fixed
Option 3: Sell the Property
Exit strategy:
- Common for investors
- Planned from beginning
- Realize capital gain
- Redeploy to new investment
Common IO Loan Mistakes
1. No Plan for IO End
IO expires Can't afford P&I increase Can't refinance (LVR too high) Forced sale
✅ Solution: Plan exit strategy from day 1
2. Treating IO as Permanent
Assume can refinance IO forever APRA tightens rules Stuck with P&I repayments Cash flow crisis
✅ Solution: Budget for P&I, use IO as bonus
3. Owner-Occupier IO with No Strategy
Paying higher rate Building no equity No tax benefit Just costs more
✅ Solution: Only use IO with clear plan (offset, temporary, etc.)
4. Ignoring Payment Shock
Budgeted for $2,800/month Jumps to $3,500/month Can't afford Financial stress
✅ Solution: Prepare for increase, refinance early, or use offset
5. Negative Equity Trap
Bought with 90% LVR Used IO, paid no principal Market dropped 10% Underwater, can't refinance
✅ Solution: Keep LVR conservative (70-80%), pay extra into offset
Tips for Interest-Only Success
Before taking IO:
- Clear purpose - Know why IO suits your situation
- Run the numbers - Compare total cost vs P&I
- Plan the exit - How will you handle IO end?
- Conservative LVR - Stay under 80% for flexibility
- Check refinance options - Can you extend IO later?
During IO period: 6. Use offset account - Reduce interest, build buffer 7. Monitor LVR - Track property value vs loan 8. Budget for P&I - Prepare for higher repayments 9. Review annually - Still best strategy? 10. Refinance early - Start 6-12 months before IO ends
Investment strategy: 11. Tax optimization - Maximize deductions 12. Debt recycling - Pay off home loan, keep investment IO 13. Portfolio approach - Some IO, some P&I 14. Professional advice - Accountant and financial planner
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