Principal and interest vs. interest only

Article by Ben Tosi

Congratulations, you’re finally ready to take the plunge into the Aussie property market! After years of strict budgeting - we’re talking economic eating, retail restraint and thrifty thinking - you’re finally ready to stump up the up-front costs associated with buying a house or apartment.

So, what is next? Well, you’ve got to start organising the small matter of financing 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 organising your home loan is whether you want to:

  • Make principal and interest repayments on your home loan, or
  • Make interest only repayments on your home loan

What you decide is likely to depend on why you bought the property, as an investor or an owner occupier, and 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 alike, read on below:

Principal and interest loans

Principal and interest loans require the homeowner to pay off part of the principal loan amount as well as cover the interest repayments. Basically, this means you’re paying off some of the amount you actually borrowed as well as keeping up with the interest repayments on the loan and for that reason is a popular choice for owner occupiers who eventually want to own their home entirely. While this may mean you’re making larger home loan repayments than you would on an interest-only loan, by paying off some of amount you initially borrowed, you’re growing your equity in the property and reducing the amount of interest you will pay over the life of the loan.

Let’s check out how your loan repayments could figure with a principal and interest loan as an...

Owner occupier

If you’re buying a home you want to live in yourself, you’ll be considered an owner occupier by your lender and will probably get a cheaper rate than if you were an investor.

Let’s say you and your partner are ready to move into your new home and need to borrow $500,000 for a 25 year home loan at an average 4% interest rate. According to Mozo’s Mortgage Repayments Calculator, you would be paying $2,639 a month on mortgage repayments which works out to be $291,755 worth of interest over the life of the loan.

Investor

If you’re looking for a property to use as an investment, you will be considered as an investor by your home loan lender and therefore will have to pay a higher interest rate than if you were an owner occupier. 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.

An investor taking out the same $500,000 home loan over 25 years at a marginally higher interest rate of 5%, will pay a greater monthly repayment of $2,923 which amounts to $376,885 worth of interest over the life of the loan. 

Interest only loans

Interest only repayments are designed for those who don’t want to pay off the principal amount of the loan and instead will only be paying the interest and any associated loan fees. More common for investors, interest only repayments can maximise cash flow and free up money for further investment.

While interest only loans are usually associated with property investors, they do serve a few functions for owner occupiers. If your budget suddenly tightens or you lose an income stream, most lenders give you the option to drop to interest only repayments for a fixed term which is usually for a maximum of five years.

So how are your interest only repayments affected as an...

Owner occupier

If you’ve decided to drop the principal repayments on your loan for a little while, your interest only repayments will definitely be lower. On that same 25 year loan for $500,000 at a 4% interest rate, your monthly repayments will drop to $1,667 a month.

But keep in mind that, while you will be paying lower repayments for a period, it is important to use interest only repayments as a short-term solution and get back to paying off the principal amount as soon as you can, especially if this is a place you see yourself living in for years to come.

Investor

If you were an investor taking out the same $500,000 for 25 years at 5% interest rate you would be paying $2,083 in monthly repayments - but remember you can claim tax deductions against the interest paid on home loans.

Investors who has been savvy enough to set up an offset account attached to their home loan will pay even less. With $50,000 sitting in an offset account, you will only be paying interest on the remaining principal amount of $450,000. This means that while the interest rate has remained the same at 5%, your monthly repayments would only be $1,875.

Whether you’re a prospective investor or potential owner occupier, find the best value home loan using Mozo’s Home Loan Comparison tables. Want to calculate your repayments? Check out our Mortgage Repayments calculator.

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