Interest-only versus principal and interest repayments

Different loan repayment types

When you apply for a home or investment property loan, you may have the option of one of these repayment types:

• principal and interest repayments

• interest-only repayments

It’s important to understand how these different types of loan repayments work and how they can change over time. Each have their advantages and disadvantages.

What is the loan ‘principle’ and what is the ‘interest’?

Your home loan is made up of two parts: the loan principal and the interest.

The loan principal is the amount you borrow to fund your property purchase. This is the difference between the full cost of the property and your deposit.

The interest is the amount you're charged by the lender for borrowing the principal amount.

Here’s what you need to know about the two most common types of loan repayments.

Principal and interest repayments

If you have this type of home loan, you’ll need to pay both the principal as well as the interest charged on it.

To begin with, you’ll mostly pay interest. But as time passes and you chip away at the loan, you’ll start paying a greater percentage of the principal.

Advantages of a principal and interest loan

• pay less interest over the life of the loan

• pay a lower interest rate compared to interest-only rates for an equivalent home loan

• pay off your loan faster, so you'll own your property outright sooner.

Disadvantages of a principal and interest loan

• repayments are higher than interest only

• may not be as tax-efficient for investment loans.

Interest-only repayments

This is when you only pay the interest portion of your loan for a set period (usually the first 5 or 10 years). Once the agreed interest-only period ends, you’ll start repaying your principal at the current interest rate at that time.

As you’re not making payments on the ‘principal’, this will remain the same, unless you choose to make additional repayments.

There are two ways you can do this. You might pay it off each month (in arrears), or once a year (in advance). ‘In arrears’ is usually at the end of each month; ‘in advance’ is in that year’s first month.

If you’re investing in property, paying interest in advance could help bring forward tax-deductible interest payments (which may reduce your taxable income). As always, it's a good idea to run this past your accountant first.

While interest-only repayments are lower during the interest-only period, you’ll end up paying more interest over the life of the loan.

There are also risks involved with getting an interest-only repayment loan. For example, if your home or investment property declines in value during the interest-only period, you could come out with no equity. Meaning, you may end up owing more than the property is worth.

Australian Securities and Investments Commission has some useful information if you’re interested in using an interest-only repayment period as part of the loan term. Check out their MoneySmart guidance for some easy to follow info graphics about the pitfalls and benefits of this type of lending structure.

They also have examples of how much you can expect to pay for this type of loan.

Advantages of interest-only loans

• lower mortgage repayments for a limited time to suit your lifestyle (e.g. taking time off work to be a primary carer)

• possible tax benefits for investment loans.

Disadvantages of interest-only loans

• principal amount will not reduce during interest-only period

• higher repayments once the interest-only period finishes

• higher interest rate during interest-only period

• more interest payable over the life of the loan.

Case study of two loan repayment types

See how the two types of loans affect John and Rebecca's repayments.

John and Rebecca have a loan of $500,000 and are deciding which repayment option is suitable for them.

The table shows the difference in interest they will pay over the life of their loan. 

Calculate and compare property loan repayments

Here is a handy home loan repayments calculator to help you calculate and compare your loan repayments. You can change between principal and interest repayments and interest-only repayments to estimate the different interest charges.

Owner occupier vs residential investor loans

These are two terms you’re likely to see when selecting a home loan or when reviewing interest rates.

Owner occupier means the person or persons living in the home own the home.

A residential investor is someone who purchases a residential home (not commercial or business property) for the purpose of renting it out as an investment.

Interest rates may differ depending on the loan type you’re choosing.

Find out more about interest only home loans

An interest only home loan means you only pay the interest component, not the balance (or principal component).

Contact us if you have any questions about these loan types.

1 Rate used in example is a variable rate which may change. We have used the same interest rate for both repayment types to easily illustrate the additional interest payable due to the five-year interest only period. Please note, interest only rates are normally higher than principal and interest rates for an equivalent home lending product.

2 Principal and interest repayments based on remaining loan term of 25 years.

Source: NAB

Reproduced with permission of National Australia Bank (‘NAB’). This article was originally published at hhttps://www.nab.com.au/personal/life-moments/home-property/pay-off-home-loan/interest-only-principal-interest

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