Interest-only loans and principal and interest home loans are two popular loan repayment options available to home buyers. However, deciding which option suits your financial situation can take time, especially if it is your first property purchase.
This article looks into the repayment types and how they can change with time to help you make an informed decision.
What is an Interest-Only Home Loan?
An interest-only home loan is one where you only repay the monthly interest portion on the borrowed amount for a set term ranging from 1 to 5 years.
With this repayment type, since you’re not making any payments on the principal amount, your loan balance will stay the same unless you decide to make extra repayments.
Once the set interest-only period finishes, your loan becomes a principal and interest loan. From here, you’ll have to start paying back the amount borrowed and interest on that amount.
With an interest-only loan, you have lesser time in the loan term to repay the principal amount. Therefore, your loan repayments will typically be higher for the rest of the loan term than if you were making principal and interest repayments from the start of your loan.
When is an Interest-Only Mortgage a Good Idea?
The interest-only repayment type often suits the following:
Property investors can use their money first to enhance the appeal of their investment properties and earn more rental income.
Speculative property investors also benefit by buying property in a rising house market, which can be sold later for a higher price. Likewise, those with stock portfolios in a solid financial market also prefer this repayment type. This is because they can make mortgage repayments without selling their investments.
2. Temporary Income Shortfall
If you’re expanding your family, switching jobs or requiring a bridging loan, an interest-only loan may help. You can make lower mortgage repayments initially. However, once the set interest-only period ends, you are better placed to pay a higher repayment amount.
Likewise, if you have a variable income, you can usually make extra payments when you have the funds to lower your principal.
Our interest-only mortgage calculator can help you determine your actual repayments for an interest-only home loan.
Pros of Interest-Only Mortgage
Here are some key advantages associated with interest-only home loans:
- Lower Repayments Initially: You have to make lower loan repayments during the interest-only period. This suits borrowers who want to reduce their monthly outgoings.
- Possible Tax Benefits: The interest deduction may help you claim tax benefits if you're in a high tax bracket.
- Improved Cash Flow: With lower repayments, you can use the money for other expenses or investments - for example, home improvements or investing in property and shares.
- Flexibility: With interest-only repayments, you can generally make extra payments to lower your principal whenever possible. This will reduce your monthly interest repayments.
Cons of Interest-Only Mortgage
Likewise, there are some downsides to interest-only home loans:
- Costly: Your principal amount stays the same during the interest-only period, and the interest rates are usually higher. Moreover, the monthly repayment increases once the interest-only period ends. This works costlier as the interest owed is higher over the life of the loan.
- No Equity Growth: Unless you make extra loan repayments, your home equity doesn't grow in the initial years as you are not repaying the loan principal. Therefore, interest-only loans are unsuitable if you want to grow your equity and pay your loan faster.
- Variable Rate Rise: Most interest-only loans come with variable interest. As a result, the interest payable during the set period may also increase, affecting your monthly budget.
What is a Principal and Interest Home Loan?
When you make home loan repayments that comprise both components, the principal balance of the loan and the interest accrued, it is known as a principal and interest (P&I) repayment.
Your home loan typically includes the principal (the amount borrowed to purchase property) and the interest portion (the cost of borrowing).
When is a Principal and Interest Home Loan Beneficial?
It’s best suited for home buyers who want to clear off the mortgage sooner and pay less interest overall gradually.
With P&I home loans, you’re repaying both the principal and the interest. This reduces paying principal owed and the overall interest over the life of your loan.
Also, the more the principal balance you repay, the greater equity you’ll have in your home.
Pros of Principal and Interest Mortgage
Here are some benefits you'll enjoy if you opt for a principal and interest repayment loans:
- More Economical: You pay a lower interest rate than interest-only rates for an equivalent mortgage and less interest over the loan’s entire life.
- Quicker Home Ownership: Unlike interest-only loans, you’re paying both the principal and interest. So, you’ll pay off your loan quicker and own your property outright earlier.
- Home Equity Growth: As your property value grows, this repayment helps maximise your equity growth by reducing your principal. This can make it a lot easier to refinance and access better loan deals.
Cons of Principal and Interest Mortgage
On the other hand, there are some limitations associated with P&I home loans:
- Higher Monthly Repayments: Since you're repaying the principal amount and interest, you'll have to make higher monthly repayments than interest-only loans.
- Not Tax-Efficient: P&I home loans may not serve tax-efficiency purposes for investment loans.
What is the Difference Between Interest-Only and Principal and Interest?
A general comparison of interest only vs principal and interest can be summarised based on the following:
- Loan Balance: With P&I repayments, you start paying down the principal balance and interest from your first repayment. In contrast, with an interest-only loan, the principal balance does not reduce, and interest continues to be calculated. So you pay more interest overall.
- Payments: With P&I repayments, your principal balance gets reduced by each repayment. With an interest-only loan, you’ll have to start paying more to pay back the principal balance and interest. Your repayments are likely to be higher after the set period ends.
- Interest Rates: P&I home loans generally have lower interest rates than interest-only home loans.
What is Better, Principal and Interest or Interest-Only?
Most Australian home buyers prefer principal and interest loan repayments.
It allows regular repayments on the amount borrowed and the interest. Also, in most cases, one can pay off the loan over an agreed loan term, for example, 25 or 30 years.
In contrast, repayments on interest-only loans may be lower during the interest-only period but will go up afterwards. So opt for them only if you can afford them.
Scenario 1: Sarah Benefits from Principal and Interest Repayments
Sarah has been in steady employment for several years. She now plans to buy her dream home and get ownership quickly.
She sees a suitable property. She borrows a $400,000 P&I repayment type loan for 30 years at a 5.94% p.a. Standard Variable Rate.
This way, her monthly repayment works to $2,383 for 30 years.
Scenario 2: James Benefits from Interest-Only Repayments
James has been working for only a couple of years and wants to purchase a house. However, he also wants to travel and would like to keep his mortgage repayments on the low side.
He also borrows $400,000. However, to match his circumstances, he considers an interest-only (5 years) repayment type for 30 years at a 6.49% p.a. Standard Variable Rate.
James has to pay $2,164 each month for five years. Thus, compared to Sarah, his monthly payments are $219 lower during the first five years of the loan term. This suits James' requirements and gives him extra money to fund his travel goals.
Notably, after the interest-only loan period ends, based on current rates (which could change), James' estimated payments over the remaining loan term will be $2,515 per month.
This means after the first five years, James will have to pay $132 more than Sarah in monthly payments for the rest of the loan term.
What to Consider Before Deciding?
Choosing between interest only vs principal and interest ultimately depends on what you use your repayment monies for and its effect on your ongoing repayments.
Also, though your repayments during the initial interest-only period will be lower, they will increase significantly after your loan converts to principal and interest repayments.
With a shorter period left to repay the principal, your home loan repayments will likely be higher over the remaining term of the loan.
How Joust Can Help
Whether you're a first home buyer or plan on buying an investment property, deciding between interest only versus principal and loans is a big decision.
Our Instant Match tool can help you find suitable home loans which fit your requirements. With a selection of competitive loan options at your fingertips, your property journey just got easier!
Note: The information in this article is general in nature and should not be considered personal or financial advice. You should always seek professional advice or assistance before making any financial decisions.