Principal and Interest vs. Interest-only Repayments

_{Photo by Monstera Production via Pexels}

Choosing the right home loan repayment option can feel overwhelming, especially when comparing principal and interest (P&I) with interest-only repayments. Both options have their advantages and disadvantages, making it important for homeowners and investors to understand the specifics.

Principal and interest vs interest only: What's the difference?

In a principal and interest loan, you're chipping away at both the amount you've borrowed (the principal) and the interest that's stacking up. It's a bit like a steady climb, gradually reducing what you owe and getting you closer to eventually owning your home outright. On the flip side, with an interest-only loan, your initial repayments are just covering the interest – the principal doesn’t cop a dent. While this might seem like a breather for your wallet at first, you're not actually getting any closer to owning your property during this interest-only period, as you’re not building any equity in your home.

What is principal and interest?

Principal and interest repayments (P&I) are the most common type of home loan repayment. Each payment you make goes towards reducing the principal (the amount borrowed) and the interest charged by the lender. Initially, a larger portion of the repayment covers the interest, but over time, as the principal decreases, the interest component reduces, and more of your payment goes towards paying off the principal.

Your loan's annual percentage rate (APR) determines the amount of interest you pay. This rate is divided by 365 to find the daily interest charged on your current loan balance. While interest accrues daily, it's typically charged monthly. The daily interest charges for the entire month is then added together to form your total monthly interest payment.

Regardless of whether you make repayments weekly, fortnightly, or monthly, they contribute towards both interest and principal. As you gradually pay down the principal, the remaining loan balance on which interest is calculated decreases. This leads to a gradual reduction in your monthly interest payments, assuming the interest rate remains constant. However, it's important to note that the specific amount of interest charged each month can slightly vary due to the different number of days in each month.

Benefits of principal and interest

• Equity building: As you pay down the principal, you increase your equity in the property, meaning that you’ll own the property outright much faster.

• Lower interest costs: Over the life of the loan, you'll pay less in interest compared to interest-only loans, as the principal decreases with each payment.

• Lower interest rate: The interest rate on a principal and interest loan is generally lower than the interest rate on an interest only loan as P&I loans are perceived as less risky.

Disadvantages of principal and interest

• Higher initial repayments: The combined principal and interest repayments are higher than interest-only payments, which might put a strain your short-term budget.

• Less cash flow flexibility: Higher monthly payments may limit your ability to invest or spend in other areas.

What is interest only?

Interest-only repayments mean that, for a set period (usually between one and five years), your loan repayments only cover the interest on the loan, not the principal. This results in lower monthly payments during the interest-only period. After this period ends, the loan reverts to principal and interest repayments, or the loan may need to be refinanced.

Benefits of interest only

• Lower initial repayments: This offers immediate budget relief, as you're not paying off any of the principal initially.

• Investment flexibility: Many investors prefer interest only loans as it frees up cash that can be invested elsewhere for a potentially higher return.

• Tax benefits for investors: Interest payments on an investment property can be tax-deductible in Australia, which can be advantageous for property investors.

Disadvantages of interest only

1. No equity build-up: Since the principal isn't being reduced, you're not building equity through repayments during the interest-only period.

2. Higher overall interest costs: Over the life of the loan, you'll end up paying more in interest because the principal isn't reduced in the early years.

3. Payment shock: When the loan reverts to principal and interest repayments, you may face a significant increase in monthly payments.

Which is better, principal and interest or interest only?

The choice between principal and interest and interest-only repayments depends on your financial goals, circumstances, and investment strategy.

If you're playing the long game, aiming to fully own your home and build equity, a principal and interest loan could be the better option. It’s a steeper climb at the start with higher monthly payments, but think of it as a solid investment in your future. Over time, you're not just paying off a debt; you're building a nest egg. The real winner here is the long-term savings, as you'll end up paying less interest over the life of the loan.

On the flip side, many investors who need greater cash flow flexibility and tax benefits in the early years opt for interest only repayments. The only catch here is that once the interest only period wraps up, you'll be back to paying both principal and interest, which can be a significant hike in your repayments. Plus, you're not building any equity during the interest-only phase, which can be a drawback if your property doesn't increase in value.

So, which is better? Well, it's not a one-size-fits-all answer. If you're looking to build equity and are comfortable with higher initial repayments, principal and interest is a solid bet. But if you need flexibility in your budget now and are focused on other financial goals or investments, interest-only could serve you well in the short term.

---

Buying a home or looking to refinance? The table below features home loans with some of the lowest interest rates on the market for owner occupiers.

Important Information and Comparison Rate Warning

---