What is a principal and interest home loan?

What is a principal and interest home loan?

If you’re in the market for a new home loan, or if you are refinancing an existing home loan, it is important to understand how you intend to repay your mortgage. 

Repayments are either made on a ‘principal and interest’ basis or they are paid by ‘interest-only’ instalments. 

Principal and interest loans

Making principal and interest (P&I) repayments helps to trim the principal (or ‘capital’), as well as the mortgage interest on the home loan. This is a popular choice for owner-occupiers. 

A P&I loan can be a competitive choice if you intend to live in the property for a long time. By paying off the capital, you not only increase your own equity stake in the property, but this strategy will result in outright home ownership. 

As you pay down the principal, you’ll simultaneously help to reduce the interest you’ll pay over the term of the loan. However, if you select a P&I option, your monthly repayments will be higher than if you make interest-only payments. 

Interest-only loans 

As the name would suggest, with an interest-only loan you only pay the mortgage interest set by the lender. This means you don’t repay any capital. 

Most lenders offer interest-only loans for a limited time – up to 5 years in some cases – after which you either need to start paying back the principal, or you must reapply to continue paying the home loan on an interest-only basis. 

Many investors choose interest-only loans as they can pay less in mortgage repayments and can easily work out a tax deductable amount to claim. First home buyers may find this an attractive loan type, particularly after the shock of initial buying expenses.

APRA crackdown on interest-only lending

Recently, lenders have been increasing interest rates for interest-only loans and the requirements to have one have become much harder (if the option hasn’t been removed completely). This is a result of a recent crackdown by APRA on risky lending practices.

 

It is important you look at the comparison rates of interest-only vs. principal and interest loans for this reason, as the money you save paying interest soon may not stack up as rates continue to rise.

How they stack up

Example – owner-occupier Alex has taken out a $350,000 home loan at a rate of 5 per cent interest over a term of 25 years. 

If she took out a P&I Loan for the whole loan term: 

Monthly repayments $2,046
Total cost of loan $613,820

If she took out a five-year interest-only loan, and then swapped to paying P&I: 

Monthly repayments (five-years interest-only) $1,458
Monthly repayments (20-years P&I) $2,310
Total cost of loan $641,863

Paying the principal and interest option will set Alex back around $2,046 per month, while the interest only option might seem more affordable at around $1,458 per month for the first five years. 

However, once that interest-only period finishes Alex will be left paying principal and interest on a 20-year loan term, which is almost $300 more expensive per month and costs her an extra $28,043 over the life of the loan. 

How do I know which is the best home loan for me? 

Choosing between principal and interest or interest-only loans is a personal decision that comes down to individual factors, including whether you’re an owner-occupier, whether you’re concerned about finances etc. 

Try using our home loan calculator to estimate your repayments and determine the total amount of interest payable over the lifetime of the loan. This should help you to determine if you can afford to pay both principal and interest. 

Compare Principal & Interest Loans:

 

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Learn more about home loans

What is an interest-only loan? How do I work out interest-only loan repayments?

An ‘interest-only’ loan is a loan where the borrower is only required to pay back the interest on the loan. Typically, banks will only let lenders do this for a fixed period of time – often five years – however some lenders will be happy to extend this.

Interest-only loans are popular with investors who aren’t keen on putting a lot of capital into their investment property. It is also a handy feature for people who need to reduce their mortgage repayments for a short period of time while they are travelling overseas, or taking time off to look after a new family member, for example.

While moving on to interest-only will make your monthly repayments cheaper, ultimately, you will end up paying your bank thousands of dollars extra in interest to make up for the time where you weren’t paying off the principal.

What is 'principal and interest'?

‘Principal and interest’ loans are the most common type of home loans on the market. The principal part of the loan is the initial sum lent to the customer and the interest is the money paid on top of this, at the agreed interest rate, until the end of the loan.

By reducing the principal amount, the total of interest charged will also become smaller until eventually the debt is paid off in full.

How can I calculate interest on my home loan?

You can calculate the total interest you will pay over the life of your loan by using a mortgage calculator. The calculator will estimate your repayments based on the amount you want to borrow, the interest rate, the length of your loan, whether you are an owner-occupier or an investor and whether you plan to pay ‘principal and interest’ or ‘interest-only’.

If you are buying a new home, the calculator will also help you work out how much you’ll need to pay in stamp duty and other related costs.

How can I pay off my home loan faster?

The quickest way to pay off your home loan is to make regular extra contributions in addition to your monthly repayments to pay down the principal as fast as possible. This in turn reduces the amount of interest paid overall and shortens the length of the loan.

Another option may be to increase the frequency of your payments to fortnightly or weekly, rather than monthly, which may then reduce the amount of interest you are charged, depending on how your lender calculates repayments.

Mortgage Calculator, Repayment Type

Will you pay off the amount you borrowed + interest or just the interest for a period?

How do I calculate monthly mortgage repayments?

Work out your mortgage repayments using a home loan calculator that takes into account your deposit size, property value and interest rate. This is divided by the loan term you choose (for example, there are 360 months in a 30-year mortgage) to determine the monthly repayments over this time frame.

Over the course of your loan, your monthly repayment amount will be affected by changes to your interest rate, plus any circumstances where you opt to pay interest-only for a period of time, instead of principal and interest.

What are extra repayments?

Additional payments to your home loan above the minimum monthly instalments, which can help to reduce the loan’s term and remaining payable interest.

What is the best interest rate for a mortgage?

The fastest way to find out what the lowest interest rates on the market are is to use a comparison website.

While a low interest rate is highly preferable, it is not the only factor that will determine whether a particular loan is right for you.

Loans with low interest rates can often include hidden catches, such as high fees or a period of low rates which jumps up after the introductory period has ended.

To work out the best value for money, have a look at a loan’s comparison rate and read the fine print to get across all the fees and charges that you could be theoretically charged over the life of the loan.

Interest Rate

Your current home loan interest rate. To accurately calculate how much you could save, an accurate interest figure is required. If you are not certain, check your bank statement or log into your mortgage account.

Who has the best home loan?

Determining who has the ‘best’ home loan really does depend on your own personal circumstances and requirements. It may be tempting to judge a loan merely on the interest rate but there can be added value in the extras on offer, such as offset and redraw facilities, that aren’t available with all low rate loans.

To determine which loan is the best for you, think about whether you would prefer the consistency of a fixed loan or the flexibility and potential benefits of a variable loan. Then determine which features will be necessary throughout the life of your loan. Thirdly, consider how much you are willing to pay in fees for the loan you want. Once you find the perfect combination of these three elements you are on your way to determining the best loan for you. 

Does Australia have no cost refinancing?

No Cost Refinancing is an option available in the US where the lender or broker covers your switching costs, such as appraisal fees and settlement costs. Unfortunately, no cost refinancing isn’t available in Australia.

Can I change jobs while I am applying for a home loan?

Whether you’re a new borrower or you’re refinancing your home loan, many lenders require you to be in a permanent job with the same employer for at least 6 months before applying for a home loan. Different lenders have different requirements. 

If your work situation changes for any reason while you’re applying for a mortgage, this could reduce your chances of successfully completing the process. Contacting the lender as soon as you know your employment situation is changing may allow you to work something out. 

Can I get a home loan if I am on an employment contract?

Some lenders will allow you to apply for a mortgage if you are a contractor or freelancer. However, many lenders prefer you to be in a permanent, ongoing role, because a more stable income means you’re more likely to keep up with your repayments.

If you’re a contractor, freelancer, or are otherwise self-employed, it may still be possible to apply for a low-doc home loan, as these mortgages require less specific proof of income.

Will I have to pay lenders' mortgage insurance twice if I refinance?

If your deposit was less than 20 per cent of your property’s value when you took out your original loan, you may have paid lenders’ mortgage insurance (LMI) to cover the lender against the risk that you may default on your repayments. 

If you refinance to a new home loan, but still don’t have enough deposit and/or equity to provide 20 per cent security, you’ll need to pay for the lender’s LMI a second time. This could potentially add thousands or tens of thousands of dollars in upfront costs to your mortgage, so it’s important to consider whether the financial benefits of refinancing may be worth these costs.