Getting a Home Loan in Australia if you're living overs...
29 Nov 2023
If you are in the market for a new home, choosing whether to opt for a principal and interest or interest only home loan is just one of the many decisions you will face. It’s important to understand how these loan structures and their repayments work, and how these can change over time.
A principal and interest (P&I) home loan is broken down into two components - the principal portion of the loan and the interest payable on the principal amount.
The principal is the loan amount borrowed from your lender to purchase the property, whereas the interest is the cost of borrowing the principal. Factors like loan interest rates, loan term, and how you manage your repayments over the life of the loan will determine how much interest you pay in total.
Principal and interest home loans are regarded as the most popular loan type for borrowers looking to achieve the great Australian dream.
With each principal & interest repayment, an increasing portion of the payment will go towards paying off the principal and a decreasing portion will go towards paying interest, since you’re chipping away at the balance owing right from the beginning.
One of the key drawcards to P&I home loans is that your home loan repayments will be lower over the life of the loan. P&I home loans will typically come with a lower interest rate, prompting for lower repayments when compared to other home loan types.
Since principal and interest repayments cover both the principal and interest, they reduce the interest you’ll pay over the course of your loan. This is because with every principal and interest repayment you make, your principal loan amount is reducing.
Seeing as you are paying off both the principal amount as well as the interest accumulated, P&I home loans can generally be paid off faster than other loan types.
Given both principal and interest are being paid off at the same time, repayments will generally be higher initially than interest-only home loans.
Typically investors will opt for interest-only home loans to save money, freeing up the principal amount of each repayment for other uses such as to save a deposit for their next property purchase or to pay off debts.
For this home loan type, the name says it all. Borrowers are only required to pay the interest on this type of loan during the interest-only (IO) period which typically is up to five years. This means your payments over the duration of this time will be less than if you were also repaying the principal.
For this reason, IO loans can be much cheaper to start with since the repayments will be much smaller. However once that IO period is over, repayments can jump significantly, and they can be more expensive overall.
Repayments are less than P&I home loans, as you’re not paying down your actual outstanding loan amount.
The lower repayments are considered to be an enticing draw card for property investors given the interest can be tax-deductible on an investment loan.
While you may be paying off interest, once the IO loan term expires the principal amount will need to be paid. This amount will remain the same – that is, your outstanding balance won’t be reduced – unless you choose to make extra repayments.
As mentioned above, once the IO loan term expires, both the principal and interest will be required to be paid. This will likely result in higher total home loan repayments.
If your property fails to increase in value during the interest-only period, it’s likely that you won't build up any equity in your property. This can potentially put you at risk if there's a property market downturn, or your financial circumstances change.
IO loans typically offer a higher interest rate than a P&I loan, meaning you pay more in interest over the life of the loan.
Now you are familiar with the advantages and disadvantages of both loan types, to compare the two let’s look at an example of a home buyer’s journey choosing between the two home loan types.
Patrick looks to purchase a $700,000 property with a home loan rate of 4.24% p.a repaid over 30 years.
|Principal & Interest||Interest Only (first five years)|
|Loan term||30 years||30 years|
|Loan term||30 years||30 years|
|Additional interest paid due to interest only period||$0||$46,660|
Choosing interest-only over a principal and interest loan to achieve his new home dreams will result in Patrick paying an extra $46,660 over the life of the home loan in interest.
Before choosing which home loan type best suits your individual financial position, be sure to chat to a financial advisor to give yourself the best opportunity to achieve your new home dreams.
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