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.
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:
|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.