When it comes to taking out real estate home loans, one may be presented with the age-old interest only vs principal and interest debate. Understanding the differences between these two options is crucial so you can assess which one matches your specific financial situation, goals, and risk tolerance.
In this blog post, we’ll explore the key features of P&I and IO home loans, and explain where each type of repayment applies. By the end of this article, you’ll have a better understanding of how home loan repayments work, and be better equipped to shop around for the right first home mortgage for you.
First off, what is the principal in a loan?
The principal in a loan is the initial amount of money borrowed from a lender. It is the amount that the borrower is responsible for paying back, not including any interest or fees that may be charged by the lender. In other words, it is the original amount of money that the borrower owes to the lender and that forms the basis for calculating the interest that accrues on the loan.
As the borrower makes repayments, the amount of the principal gradually decreases until the loan is fully paid off.
What is an interest only home loan?
An interest-only home loan is a type of mortgage in which the borrower is only required to pay the interest on the loan for a certain period, typically 5-10 years. During this time, the borrower does not pay down any of the principal amount of the loan.
As a result, the monthly payments on an interest-only loan are typically lower than on a traditional loan with principal and interest payments. After the interest-only period ends, the borrower must begin making payments on both the principal and interest, which typically results in higher monthly payments.
Interest-only loans can be attractive to property investors who may be looking to minimise their initial repayments or maximise their tax deductions. However, there are risks associated with interest-only loans, including the potential for higher costs in the long run and the possibility of negative equity if property values decline.
What is a principal and interest loan?
A principal and interest (P&I) loan is a type of home loan where the borrower makes regular repayments that cover both the principal amount borrowed and the interest charged on the loan. The principal is the amount of money that was borrowed to purchase the property, and the interest is the additional cost charged by the lender for borrowing that money.
With a P&I loan, each repayment reduces the outstanding balance of the loan and pays off a portion of the principal, as well as the interest. So over time, the amount of interest charged on the loan decreases, and the amount of the repayment that goes towards reducing the principal increases. Eventually, the loan will be fully paid off, and the borrower will own the property outright.
For example: 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.
P&I loans are often preferred by owner-occupiers because they provide a clear path towards paying off the loan and owning the property. They also often come with lower interest rates compared to an interest only home loan, which saves borrowers money over the life of the loan.
What is the difference between a principal and interest loan and an interest only loan?
To show you the difference between these two, here’s a video comparing them.
Here’s a table that illustrates the difference between these two types of repayments:
Principal and Interest Loan | Interest Only Loan | |
---|---|---|
Definition | Regular repayments of both principal and interest | Regular repayments of only interest, with the principal repaid at the end of the loan term or in a lump sum |
Repayment structure | Pay down both principal and interest with each repayment | Pay only the interest amount with each repayment |
Loan term | Typically up to 30 years | Typically up to 5-10 years |
Monthly repayments | Higher due to paying off principal and interest | Lower due to paying only interest |
Interest rate | Usually lower than interest-only loans | Usually higher than principal and interest loans |
Equity build-up | Builds equity in the property over time | May not build equity if property value does not increase |
Interest only vs principal and interest: when do the different repayments apply?
When it comes to taking out loans for properties, it’s important to consider the type of debt and the repayment options that suit your financial goals. As a general rule, it’s recommended to opt for interest-only loans for investment properties and principal and interest loans for owner-occupied homes.
Investment loans: interest only (if you also have an owner occupied debt)
Owner Occupied: principal and interest
Why is this the case? For your own home, the goal is usually to pay down the debt and eventually own it outright. This not only provides a sense of security, but also frees up your income for other expenses during retirement. In contrast, investment properties are often purchased with the intention of selling them after 10 years, so it makes sense to keep the repayments to a minimum and take advantage of tax-deductible interest.
By choosing interest-only repayments, you can significantly reduce your holding costs for a property. For example, a $300,000 loan with a 5% interest rate over a 30-year term would require principal and interest repayments of $1,610 per month. However, by choosing interest-only repayments, the cost drops to $1,250 per month, which could free up $360 each month to put towards your owner-occupied debt.
Of course, it’s important to keep in mind that while interest-only loans can be beneficial for investment properties, they do come with some risks. It’s crucial to have a solid plan in place for paying off the debt eventually and to be prepared for any changes in interest rates or rental income.
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