Interest only vs principal and interest home loans

Deciding between interest only, and principal and interest repayments

Interest only, and principal and interest loans are not separate types of home loans. Rather, they are two different ways of making loan repayments. For example, if you take out a variable rate home loan, the lender may offer you the choice of making interest only payments or principal plus interest repayments.

It’s worth knowing the difference between interest only vs principal and interest, as the option you select can impact the size of your repayments and the total interest paid over the life of the loan.

What is the loan ‘principal’?

The loan ‘principal’ refers to the loan balance. If you borrow $500,000 to buy a home, this is the value of the principal at the beginning of the loan term. Over time, the principal – or outstanding balance – can change as you whittle away the debt through regular repayments and possibly extra payments.

What is the loan ‘interest’?

When you take out a mortgage, the lender charges interest on the principal. It’s how lenders make money. They charge you a percentage of the principal, known as the interest rate.

What are principal and interest payments?

With principal and interest payments, each regular repayment you make is made up of loan interest plus a small slice of the loan principal. In this way, the loan is paid off in full over the term you select.

What are interest only payments?

If you choose an interest only home loan, you still need to make regular loan payments. The difference is that each payment is only made up of interest charges. You do not pay off any of the principal, or loan balance, at all. This being the case, the repayments will be less than if you opt for principal and interest payments.

An example illustrates the difference between the two types of loans:

The Canstar mortgage calculator shows that on a loan of $500,000 with an interest rate of 5.25% and a term of 25 years:

• Principal and interest repayments: $2,996 each month. You will have paid back the entire loan at the end of the term.

• Interest only repayments: $2,188 a month. You won’t make any inroads into paying down the $500,000 loan balance. The principal owed will stay the same during the interest only period.

Why make interest only payments instead of principal and interest?

There can be a number of situations when making interest-only payments on a home loan might be appealing. These include:

• You are a property investor. For investors, interest only payments can be a way of maximising the cash flow and tax deductions on a property. An investor who plans to hold a property for just a short time with hopes of reselling the place at a profit for instance, may have little motivation to pay down any of the loan principal.
• You wish to temporarily reduce your loan repayments. There may be times when your income will temporarily reduce, like if you’re heading off on parental leave or taking a break from work for study. Opting to make interest only repayments can be a way of trimming back your home loan repayments while you are earning less.

Choosing between a principal and interest loan vs an interest only loan

The opportunity to reduce your home loan repayments by making interest only payments can be tempting, especially if cash is tight. However, there are potential pros and cons for both types of loan payments.

Principal and interest payments: potential pros

If you’re considering principal and interest payments, there can be some valuable upsides:

• Your home loan balance will reduce over time. If you are buying a home with the intention of living in it for some years, making principal and interest repayments will help you own the property debt-free at some stage – and for many home owners that’s a key goal.

• You can save on interest costs. Making principal and interest payments can help to lower the long term interest costs of the loan. As loan interest is charged on the outstanding balance, the interest payable will reduce over time. This can mean paying less interest over the life of the loan compared to an interest-only loan.

Principal and interest payments: potential cons

There are potential drawbacks to principal and interest payments:

• Your loan repayments will be higher. As part of each loan repayment goes towards reducing the principal, the regular repayments will be higher (assuming the same loan rate) compared to interest only payments.

Interest only payments: potential pros

Choosing an interest only home loan may offer certain advantages:

• Your home loan payments are lower. Without the need to pay off any of the loan balance, the regular payments should be lower with interest only loans. This can be especially useful for investors as it frees up extra cash that may be used to fund other investments.

Interest only payments: potential cons

Interest only home loans can have disadvantages including:

• Interest rates for interest only loans tend to be higher. The interest rate on interest-only home loans can be higher than principal and interest loans. This makes it important to shop around and compare interest only home loans.

• Lenders typically impose limits on interest only terms. These time frames can vary depending on whether you are an owner occupier or an investor. With CommBank for instance, home owners can make interest only payments for up to five years. For property investors it may be possible to make interest only payments for up to 10 years.

• At some stage you may have to revert to principal and interest payments. When an interest only term expires, you can apply to the lender to extend the interest only term though there is no guarantee they will agree to this. If your request is knocked back, you may need to adjust your budget in preparation for making higher principal and interest payments. Or, if you’re keen to stay with interest only payments, you could consider refinancing the loan to a different lender. You can compare refinance loans with Canstar.

• You could pay more interest over the life of the loan. The total interest paid over the life of the loan will be higher when you make interest only payments. This reflects the combination of a higher interest rate, and the fact that the loan balance is not reduced at all during the interest-free period.

• Home owners may not be offered interest only payments. Interest only payments tend to be favoured by investors. Not every lender will offer interest only payments to home buyers.

Can I make interest only payments if I’m struggling with high interest rates?

The Australian Banking Association advises that it may be possible to switch to interest only payments if you’re struggling to stay on top of your loan repayments. However, this is something to speak to your lender about as you may need to meet eligibility requirements. It might also be a wise idea to seek suitably qualified independent advice.

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