Home loan repayments: principal and interest vs. interest only

So you’ve saved up a deposit and are ready to take the plunge into the Aussie property market. Now there’s just the small matter of organising a home loan. And considering this is an expense that you could potentially carry for the next 30 years, you’re going to want to do it right.

One of the major decisions you’ll have to make when setting up your home loan is whether you want to make:

• Principal and interest repayments, or

• Interest only repayments

What you decide will depend on your reasons for buying the property as well as your unique financial circumstances. For a breakdown of what you need to know about each repayment type and what they mean for owner occupiers and investors, read on below.

Principal and interest loans

As the name suggests, principal and interest loans require borrowers to pay off their principal balance and the interest it accrues at the same time. While this means you’ll be making larger home loan repayments than you would on an interest-only loan, by doing so you can grow equity in your property and reduce the amount of interest you’ll pay at the same time.

P&I loans for Owner Occupiers

If you’re buying a home you intend to live in yourself, you’ll be considered an owner occupier by your lender and will probably get a slightly cheaper rate than the ones it offers to investors. But just how much can you expect to pay?

Let’s say you take out a loan of $500,000 for 25 years at the current average average interest rate of 3.34% p.a. According to our mortgage repayments calculator, your monthly repayments would be $2,460, and over the life of the loan you’ll pay $238,125 in interest.

P&I loans for Investors

While investors usually opt for interest only loans, you can still choose to make principal and interest repayments if you’re keen on owning the property outright in the future. Just keep in mind that if you’re buying a home for investment purposes, you’ll likely have to pay a higher interest rate than if you were an owner occupier. 

For example, an investor taking out a $500,000 home loan over 25 years at a marginally higher interest rate of 3.76% p.a. (the current average for home loans of this type) will be making monthly repayments of $2,573, which amounts to $272,013 worth of interest over the life of the loan.

Interest only loans

On an interest only loan, borrowers will pay down just the interest portion (along with any associated fees) for a fixed amount of time. Since your repayments won’t go towards paying off the principal, it will remain the same unless you choose to make extra repayments. 

IO loans for Owner Occupiers

While interest only loans are usually associated with property investors, they can also be useful for owner occupiers. For example, if your budget suddenly tightens or you lose an income stream, lenders might allow you to make interest only repayments for a certain amount of time (usually no more than five years).

Switching from principal and interest repayments to interest only repayments can give your budget significant breathing room. To illustrate, on a $500,000 loan paid over 25 years at a variable rate of 3.34% p.a., your monthly repayments will drop from around $2,460 to $1,392.

Just keep in mind that while your repayments will be lower for the time being, the principal amount will continue to collect interest, which may mean you’ll pay more over the life of the loan. For this reason, interest only repayments should only be utilised as a short-term solution.

What’s more, once the interest only period ends, your repayments will probably be higher than before, since your lender will have adjusted the terms of your loan to make sure you’re still able to pay it off within the agreed upon timeframe.

IO loans for Investors

Interest only loans are commonly taken up by investors, since they can help maximise cash flow and free up money for further investment. At the current average rate of 3.99% p.a., an investor taking out an interest only loan of $500,000 for 25 years would pay $1,663 each month. But remember you can also claim tax deductions against the interest paid on home loans.

Whether you’re a prospective investor or potential owner occupier, find the best value home loan using our home loan comparison tables. And if you want to calculate how much you could be paying, check out our mortgage repayments calculator.