Buying guide
Interest-only mortgages: A guide for property investors & homeowners
Considering going interest only? Here’s everything you need to know.
Last updated: 12 March 2024
The vast majority of mortgages in New Zealand are principal and interest, meaning you make repayments on the original loan amount (the principal), plus interest. However, there is an alternative.
An interest only mortgage can be a tempting way to reduce costs in the short term but this comes with a number of risks. Here’s everything you need to know.
What is an interest only mortgage?
Interest only mortgages are home loans that only require the borrower to make interest payments. For the interest only period, typically less than five years, you won't make any repayments towards the principal (original amount) of the loan.
You still own your property and are allowed to live in it or rent it out with an interest only mortgage. However, you won’t make any progress reducing the loan principal amount with your repayments.
Why use an interest only mortgage?
Investors: for tax purposes
Mortgage interest is partially tax deductible on investment properties, and will be fully deductible by 2025 (in other words, if you pay more interest, you pay less tax).
For example, let’s say an investor has two mortgages, one on their home and one on their investment property. With an interest only mortgage they can free up cash to pay more off their loan on their primary home, while paying less tax on their investment.
Doing this can also free up cash flow to renovate an investment or buy more property.
Owner-occupier: to help with short-term financial difficulty
Switching to interest only repayments can be a way to reduce the cost of your mortgage to help with short term financial difficulty. This might be ideal for first home buyers who’ve stretched to buy their home and need to cover purchase costs. Of for families where one income earner is temporarily unable to work, or home-owners who’ve been hit by unexpected costs.
Whatever the reason, it’s important that an interest only loan is used as a last resort - these loans may have lower repayments now, but you’ll pay far more interest over the life of the loan (more on this later).
Owner-occupier: to leave room for renovation expenses
If you’re renovating your home, or adding an extension, switching to interest only repayments can help reduce your costs temporarily. This might make it easier for you to afford your alterations.
For flexibility
While you don’t have to, you can choose to make principal repayments without penalties when you have an interest only loan with a variable interest rate. That can be ideal for borrowers whose income goes up and down, or those who are changing jobs - these borrowers may want to make principal repayments during some months, and only interest during others when money’s tight.
An interest only mortgage can be a way to ease financial strain as a last resort.
The risks of interest only
Interest only mortgages cost more overall
With regular principal and interest loans you’ll steadily reduce the loan amount over time, and you won’t be paying interest on the principal that you’ve already paid off. With an interest only loan your principal stays the same during the entire period, which means you’ll pay more interest overall.
In our example below a borrower with a $500,000 loan paid $37,055 more with an interest only period of five years.
When your interest-only period runs out your repayments will increase
When your interest only period ends your regular repayments will increase, sometimes substantially. If you can’t afford these higher mortgage repayments you’ll have no choice but to either:
Sell your house.
Extend your home loan period: which will mean paying even more interest.
Ask for a repayment holiday from your bank if you’re experiencing financial hardship.
If house prices were to fall, you could get into trouble
If house prices fall during your interest only period you may be left with a house that’s worth less than your mortgage because you haven’t been reducing the principal.
Let’s say you borrowed $500,000 to buy a new build home worth $550,000 with an initial interest only period of five years.
If house prices were to fall by 15% over five years your house would be worth $32,500 less than your mortgage ($467,500).
If this were to happen it may be difficult to refinance and banks may even ask for you to provide more equity. In this example you may be required to top up your loan with $82,500 cash to restore your equity.
If you’re not able to do this, and you can’t figure out another option, the bank may repossess your home and sell it to repay the loan. You’ll lose your $50,000 deposit and your home.
While this is an extreme example, the risks of an interest only loan usually outweigh the benefits, even for investors. So before you decide on an interest only mortgage you should consider the risks in detail, run the numbers several times and seek financial advice.
Your interest rate may be higher
Some lenders only offer interest only home loans with variable interest rates, which tend to be higher than fixed interest rates. Others will offer fixed interest rates but these may be slightly higher than those offered to borrowers making principal and interest repayments.
It may be more difficult to get approval
When lenders assess whether you can afford a principal and interest home loan they’ll look at whether or not you can afford to repay the loan in thirty years (assuming you’re making a new application).
On the other hand, if you apply for a loan with an initial interest only period of five years your lender will assess whether or not you can afford to repay the loan over 25 years. Because repayments will be higher during that time, banks will require a higher income to service that debt and it may be more difficult to get approved.
What happens when an interest only loan expires?
When the interest only period on your mortgage expires you will need to either repay the principal amount or switch to principal and interest repayments. If you choose to do the latter, your regular repayments will increase substantially.
For example, if you were paying interest only on the average home in NZ* your monthly repayments would be $1,922. When you switched to principal and interest, your repayments would increase by more than $3,000.
How long can you pay interest only on a mortgage
Most lenders will provide an interest only mortgage for a maximum of five years. However, it may be possible (but not recommended) to refinance an interest only mortgage to another lender to continue paying interest-only, or extend the interest only period with your existing lender.
Some non-bank lenders also offer interest only mortgages for longer than five years - up to 20 years. These usually require a larger deposit of 50% and have higher interest rates.
Most loans are principal and interest but there is a place for interest only.
How much do interest only mortgages cost?
An interest only period at the start of a mortgage can substantially increase the overall cost of a home loan. Here’s an example:
Interest only period of five years
Original loan amount (7.9% interest rate, 30 year term) | Interest paid | Total paid |
$500,000 | $845,305 | $1,345,305 |
In this example your repayments would start at $3,292 and increase to $3,826 after your interest only period runs out.
Principal and interest repayments
Original loan amount (7.9% interest rate, 30 year term) | Interest paid | Total paid |
$500,000 | $808,250 | $1,308,250 |
The above loan would cost you $37,055 less than the interest only option and your repayments during the last 25 years of the loan would be about $200 lower per month.
Getting advice before you apply for an interest only home loan
Unless you’re an experienced investor with an eye for numbers, it’s always best to get advice from an expert before applying for an interest only mortgage. This could be either a mortgage broker or a financial advisor.
They’ll be able to assess your goals and financial situation, run the numbers, and tell you whether or not an interest only home loan is right for you. This will not only give you peace of mind, it could save you thousands of dollars and plenty of stress.
*Assuming a property with an average asking price on Trademe.co.nz in December 2023 of $864,350, a 20% deposit, an interest rate of 7.89% and a 30 year term.
DISCLAIMER: The information contained in this article is general in nature. While facts have been checked, the article does not constitute a financial advice service. The article is only intended to provide general information about interest only mortgages in New Zealand. Nothing in this article constitutes a recommendation that any type of loan is suitable for any specific person. We cannot assess anything about your personal circumstances, your finances, or your goals and objectives, all of which are unique to you. Before making decisions about an interest only mortgage, we highly recommend you seek professional advice.
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