Principal and interest vs interest-only: what's best for you?

When you apply for a home loan, you will have the option to choose between two repayment types: principal and interest, or interest-only repayments. If it’s your first time applying for a home loan, these might sound like foreign concepts — but it’s important to understand the difference between principal and interest vs interest only.

In this blog, we explain the differences, advantages and disadvantages of principal and interest vs interest only so you can make an informed decision about your home loan!  

 

Before we dive in…

 

 

It’s important to understand what principal and interest are. The two biggest components of your home loan repayments are usually the principal and interest components. Your home loan principal is the amount of money you borrowed from your bank or lender. The interest is the cost the bank or lender charges to let you borrow the money. Together, the loan amount, interest rate and, the loan term determine how much you repay over the loan's lifespan.

 

 

Principal and interest vs interest-only

 

Principal and interest loans

With this kind of loan, you will need to pay both the principal and the interest charged on it each month. Your loan will come with a specified term, usually no longer than 30 years. Your lender will work out the minimum principal and interest repayment amount needed to repay the loan within that time.

Advantages	Disadvantages	Who would suit this loan?
You will pay less interest over the life of the loan than an equivalent interest only loan. You are likely to pay a lower interest rate than an interest-only rate for the same home loan, saving you interest. You will pay off your loan faster and own your home sooner.	The repayments are higher than interest-only loans. It may not be as tax-efficient for investment loans.	Owner-occupiers — your lender will likely give you a slightly cheaper rate than investors. Property investors who want to pay down their home loan and increase their equity in an investment property.

Here’s a quick example.

Beth has a $450,000 owner-occupier loan and wants to pay off her loan quickly so she can build up some equity. She makes principal plus interest payments of $1,897 each month. Over the next three years, Beth pays a total of $68,000 in loan repayments and reduces the principal balance of her loan by $30,000 down to $420,000.

 

Interest-only loans

An interest-only loan is where you only pay the interest portion of your loan for a set time e.g. the first five years of your loan. Because you aren’t making payments on the principal, the principal will remain the same unless you choose to make extra payments.

At the end of the interest-only period, you will need to start paying off the principal at the current interest rate. Essentially, you are pushing back the inevitable to suit your lifestyle and your ability to repay your loan.

The downside is that the repayments will also be higher when the interest-only period ends and the total repayment amount will be more over the loan's lifespan.

Advantages	Disadvantages	Who would suit this loan?
Lower mortgage payments for a limited time. Possible tax benefits for investment loans.	The principal will not reduce during the interest-only period. There will be higher repayments when the interest-only period ends. There is likely to be a higher interest rate during the interest-only period. There is more interest payable over the life of the loan.	Property investors looking to maximise their cash flow and give them a buffer to invest elsewhere or when building a new house. First-home buyers who may need a more affordable home loan (at least in the interim).

Here’s a quick example.

Scott has a $450,000 investor loan and only wants to make interest repayments. He only pays the monthly interest of $1,146. Over the next three years, Scott pays $41,300 in interest-only loan repayments but does not reduce the loan's principal balance. The balance remains at $450,000.

 

FAQs about these repayment types

What are the risks of an interest-only loan?

The main risk associated with interest-only loans is whether or not you can afford principal and interest repayments once the interest-only period ends. This can be especially risky for first-time home buyers — cheaper repayments for the first five years of your mortgage can sound appealing. Still, it’s important to consider whether or not you will be able to afford repayments once you start making principal and interest repayments.

What kind of borrowing power will I have with an interest-only loan?

For interest-only loans, most lenders buffer repayments on the residual principal and interest loan term — for example, if you had a loan term of 30 years with a five-year interest-only period, your borrowing power would be calculated as if you were on a 25-year loan. This significantly reduces your borrowing power.

However, if you have existing interest-only loans, some lenders will use the actual repayments plus a small buffer e.g. a slightly higher interest rate. In this case, the interest-only repayments on your existing loans may actually allow you to borrow more.

I’m looking into investment properties. What kind of loan is best for me?

The loan that is best for you will depend on your individual circumstances and objectives. You should discuss your goals with your lender or broker to work out which option is right for you.

 

We can help you choose between principal and interest vs interest-only loans

Purchasing a new home or investment property should be exciting, not confusing. At Gateway Bank, we want to make the purchasing process as simple and stress-free as possible, which is why our team is here to field any questions you may have about principal and interest vs interest-only loans.

For more information, feel free to give us a call on 1300 302 474 or contact us online now — our team will be in touch as soon as possible to talk you through our different loan options and pair you with a loan that meets your needs and your home ownership goals.