Principal & Interest vs Interest Only
If you are in the market for a new home, choosing whether to opt for a principal and interest or interest only home loan is just one of the many decisions you will face. It’s important to understand how these loan structures and their repayments work, and how these can change over time.
What is a Principal and Interest home loan?
A principal and interest (P&I) home loan is broken down into two components - the principal portion of the loan and the interest payable on the principal amount.
The principal is the loan amount borrowed from your lender to purchase the property, whereas the interest is the cost of borrowing the principal. Factors like loan interest rates, loan term, and how you manage your repayments over the life of the loan will determine how much interest you pay in total.
Principal and interest home loans are regarded as the most popular loan type for borrowers looking to achieve the great Australian dream.
With each principal & interest repayment, an increasing portion of the payment will go towards paying off the principal and a decreasing portion will go towards paying interest, since you’re chipping away at the balance owing right from the beginning.
P&I home loan advantages
Lower repayments over loan life
One of the key drawcards to P&I home loans is that your home loan repayments will be lower over the life of the loan. P&I home loans will typically come with a lower interest rate, prompting for lower repayments when compared to other home loan types.
Less interest over the life of the loan
Since principal and interest repayments cover both the principal and interest, they reduce the interest you’ll pay over the course of your loan. This is because with every principal and interest repayment you make, your principal loan amount is reducing.
Pay off home loan faster
Seeing as you are paying off both the principal amount as well as the interest accumulated, P&I home loans can generally be paid off faster than other loan types.
P&I home loan disadvantages
Repayments are higher initially than other loan types
Given both principal and interest are being paid off at the same time, repayments will generally be higher initially than interest-only home loans.
Not suited for investors
Typically investors will opt for interest-only home loans to save money, freeing up the principal amount of each repayment for other uses such as to save a deposit for their next property purchase or to pay off debts.
What is an Interest-Only home loan?
For this home loan type, the name says it all. Borrowers are only required to pay the interest on this type of loan during the interest-only (IO) period which typically is up to five years. This means your payments over the duration of this time will be less than if you were also repaying the principal.
For this reason, IO loans can be much cheaper to start with since the repayments will be much smaller. However once that IO period is over, repayments can jump significantly, and they can be more expensive overall.
IO home loan advantages
Lower repayments initially
Repayments are less than P&I home loans, as you’re not paying down your actual outstanding loan amount.
Tax deductible
The lower repayments are considered to be an enticing draw card for property investors given the interest can be tax-deductible on an investment loan.
IO home loan disadvantages
Principal amount remains the same
While you may be paying off interest, once the IO loan term expires the principal amount will need to be paid. This amount will remain the same – that is, your outstanding balance won’t be reduced – unless you choose to make extra repayments.
Higher repayments once IO term ends
As mentioned above, once the IO loan term expires, both the principal and interest will be required to be paid. This will likely result in higher total home loan repayments.
Equity risk
If your property fails to increase in value during the interest-only period, it’s likely that you won't build up any equity in your property. This can potentially put you at risk if there's a property market downturn, or your financial circumstances change.
Higher interest rate
IO loans typically offer a higher interest rate than a P&I loan, meaning you pay more in interest over the life of the loan.
Principal and Interest vs Interest-Only
Now you are familiar with the advantages and disadvantages of both loan types, to compare the two let’s look at an example of a home buyer’s journey choosing between the two home loan types.
Patrick looks to purchase a $700,000 property with a home loan rate of 4.24% p.a repaid over 30 years.
| Principal & Interest | Interest Only (first five years) | |
|---|---|---|
| Loan amount | $700,000 | $700,000 |
| Interest rate | 4.24% | 4.24% |
| Loan term | 30 years | 30 years |
| Loan term | 30 years | 30 years |
| Additional interest paid due to interest only period | $0 | $46,660 |
Choosing interest-only over a principal and interest loan to achieve his new home dreams will result in Patrick paying an extra $46,660 over the life of the home loan in interest.
Before choosing which home loan type best suits your individual financial position, be sure to chat to a financial advisor to give yourself the best opportunity to achieve your new home dreams.
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About the article
As Australia's leading online lender, loans.com.au has been helping people into their dream homes and cars for more than 10 years. Our content is written and reviewed by experienced financial experts. The information we provide is general in nature and does not take into account your personal objectives or needs. If you'd like to chat to one of our lending specialists about a home or car loan, contact us on Live Chat or by calling 13 10 90.
