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What is principal and interest?
Principal and interest is a type of loan where the borrower repays the loan as well as the interest charged by the lender from the very start of the term. In other words, from the beginning, your regular repayments will go towards paying down the loan amount (the principal) as well as the interest that’s added on top.
Principal and interest is generally the most commonly-offered loan set up, with the main alternative being an interest-only loan. With that kind of loan, your repayments only cover the interest charged by the lender for a period of time, usually up to five years in the case of a home loan. After this period, the loan reverts to principal and interest repayments for the remainder of the term.
How do principal and interest loans work?
With a home loan, the lender charges interest based on an annual percentage rate. Using that rate, interest is typically calculated each day on the loan’s current balance and the interest amount is divided by 365 to give the daily interest amount. As interest is usually charged monthly, the daily interest amounts for the month are added together and that total is added to your loan balance.
With a principal and interest loan, your regular repayments – whether they are weekly, fortnightly or monthly – pay off the interest plus a chunk of the loan balance. That way you are gradually eating away at the loan amount, so each month the amount of interest you are charged should progressively decrease, assuming your interest rate does not change. The amount of interest charged can also fluctuate depending on the number of days in the month.
Of course, interest is just one of the costs of taking out a loan. It’s also important to consider the fees charged. For this reason, loans are advertised with an interest rate and a comparison rate, which is designed to give borrowers a more accurate picture of the cost of the loan as it factors in the interest rate and most fees based on a sample loan amount and term.
This graph demonstrates what a hypothetical $400,000 principal and interest home loan balance would look like over time as it’s gradually paid off.
Based on the average owner-occupier variable interest rate on Canstar’s database of 3.36% as at 9/11/2020 for loans of $400,000 with 80% loan-to-value ratio (LVR) and principal & interest repayments, excluding first home buyer-only and introductory loans. Scenario assumes a total loan term of 30 years. Loan fees are not included in the calculation.
Which is better: principal and interest or interest-only?
Whether a principal and interest or interest-only home loan is the better option for you will depend on your circumstances and priorities. Here are some potential benefits of each which may help you decide which repayment type is right for you.
Benefits of principal and interest repayments
- Interest rates on offer with principal and interest loans are generally lower than interest-only loans.
- As you are progressively paying down the balance from the start of the loan term, you generally end up paying less in interest over the life of the loan, compared to an interest-only loan.
- With a principal and interest loan, you are building up equity in your home from the start as the balance decreases.
Benefits of interest-only repayments
- Your regular repayments will generally be lower during the interest-only period than they would be with a principal and interest loan.
- Lower repayments during the interest-only period may mean you have more cash available to use for other purposes.
- For investors, opting for an interest-only home loan may offer potential tax benefits, according to Moneysmart.
How to compare principal and interest home loans
With a principal and interest home loan, the interest you pay is typically the biggest cost aside from the principal you borrow, so it’s worth paying close attention to the rate you’re charged at. It can also be worth bearing in mind the fees charged by your lender, such as establishment fees and annual or monthly fees. This is why the comparison rate can be useful for borrowers looking to weight up the interest rate as well as fees.
Loan features can also contribute to the overall value you’re getting and can be worth factoring in when you’re comparing your options. For example if you have a principal and interest loan that allows you to make extra repayments so you’re paying off even more of the loan’s principal ahead of time, this could help you save quite a bit of money in interest in the long run. Alternatively, an offset account could help you save in interest too.
Main image source: jax10289 (Shutterstock).