With all loans there is two types of repayments. Principle & Interest or Interest Only. When do you use the different types is a questions I encounter frequently. ‘
Firstly lets discuss what they mean…
As the name suggests Interest Only is where you only pay back the interest. The loan amount does not change over the term of the loan. Your monthly repayments are only paying the bank the interest charged on the mortgage. Interest only loans can only be paid monthly as the interest in only charged once a month by the lenders. Whereas Principle & Interest you are paying off the loan amount known as the principle. Each loan repayment includes the interest charged by the bank plus a portion of the loan amount. Over a period of time the loan amount decreases. If you have a 30 year term by the end of the 30 years your loan balance will be $0. With P+I loans you can make weekly, fortnightly or monthly repayments
When do the different repayments apply? Below is what I generally stick with.
Investment loans – interest only (if you also have an owner occupied debt)
Owner Occupied – principle & interest
Why? Owner occupied homes we generally want to pay down the debt. We want to own our houses outright. There is no better feeling than not having to pay a mortgage each week/month. Owning your house outright by retirement age puts you in a very secure position and preserves your superannuation for living expenses and lifestyle. Investment properties are generally purchased with the intention of selling after 10 years. The interest is tax deductable. It does not make sense to be paying down a tax deductable debt unnecessarily when you could be putting all of this extra money towards your owner occupied debt. Then once you have cleared your owner occupied debt you can look at paying down your investment debt. Paying interest only minimises your repayments. For example a $300K loan at 5% interest over a 30 year term have P+I repayments of $1610 p/m where if you are paying I/O the repayments are only $1250. If you were to pay interest only in this example there could potentially be an extra $360 that you could contribute towards your own mortgage each month.
The other main reason investors choose to pay interest only repayments is to reduce the holding costs for a property. As with the example given above to hold a property with I/O repayments is $360 per month cheaper and reduces the amount of money the investor have to fork out of their own pocket.