Principal & Interest vs Interest Only
A home loan is a long-term commitment that can significantly impact your finances. Choosing the right one is incredibly important, but with so many options, figuring out which loan option is best for your situation can be a challenge.
It’s important to understand how home loans are structured, how repayments work, and how they can change over time. In this article, we break down interest only and principal and interest home loan repayment types by comparing their benefits and drawbacks.
What is a principal and interest home loan repayment?
A principal and interest home loan repayment is broken down into two components: the principal loan amount (i.e., the amount you originally borrowed) and the interest payable on the principal amount. The interest you pay in total depends on interest rates, loan term, and how you manage your repayments over time.
This type of loan repayment covers the principal amount and interest costs. 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.
Principal and interest home loans are regarded as the most popular loan type for borrowers.
Advantages and disadvantages of principal and interest home loan repayments
Benefits of a principal and interest home loan repayment
Most borrowers with a principal and interest mortgage repayment enjoy lower interest costs over the life of the loan, as well as a lower repayment amount from the outset compared to an interest only loan. Here’s a quick look at the benefits of a principal and interest home loan:
Lower repayments
Your repayments could be lower over the life of the loan. Although the initial principal and interest repayment amount will be higher compared to an interest-only repayment, when the interest-only repayment period expires, the principal and interest repayment amount will typically be higher.
Additionally, principal and interest repayment types generally attract a lower interest rate, prompting lower repayments.
Less interest paid
Since this type of loan covers both the principal and interest, you will pay less interest over the course of your loan than you would on an interest only loan. With every principal and interest repayment you make, your principal loan amount is reduced.
Pay off your home loan faster
In some cases, a principal and interest repayment type can assist you with paying off your loan sooner. As you continue to pay down the principal balance with each repayment, you’ll be charged less interest. This could open up a good opportunity later down the track to start making extra payments to your loan (if your loan type and lender allow).
Drawbacks of a principal and interest home loan
The main disadvantage of a principal and interest home loan is the higher initial repayment amount. Because you’ll be paying both the principal amount borrowed and the interest cost, your repayments will be higher compared to an interest only home loan.
What is an interest only home loan repayment?
For this home loan repayment type, the name says it all. Borrowers are only required to pay the interest during the interest-only period, which is typically up to five years. During this time, you won’t be making payments towards the principal loan amount, making initial repayments much lower compared to the principal and interest home loan.
Many opt for an interest only home loan because it’s much cheaper to start with. However, once the interest-only period is over, repayments can jump significantly and become more expensive overall because you will be required to pay back the principal loan balance owing in a shorter period of time.
Advantages and disadvantages of an interest only home loan
Benefits of an interest only home loan
Interest only home loans offer borrowers a few advantages, such as:
Lower initial repayments
During the interest-only period, the repayment amount for this type of loan is considerably less compared to a principal and interest home loan. Since you’re only paying the interest on your loan, you have extra cash flow.
Tax deductible
The interest payments on an investment home loan could be tax-deductible for some investors. It’s best to consult with an accountant or tax expert to see how you can maximise the possible tax benefits of an interest only investment home loan.
Disadvantages of an interest only home loan
The lower repayments may sound alluring, but interest only home loans do have a few drawbacks. One of the main downsides of an interest only home loan is the higher interest rates.
There’s also the equity risk with an interest only loan. If your property fails to increase in value during the interest-only period, you likely won't build up any equity in your property.
Principal and Interest vs Interest Only
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.
| Principal & Interest | Interest Only (first five years) | |
|---|---|---|
| Loan amount | $700,000 | $700,000 |
| Interest rate | 5.79% | 5.99% |
| Loan term | 30 years | 30 years |
| Monthly repayments | $4,103 | $3,494 |
| Repayments after the interest-only period expires | N/A | $4,506 |
| Total interest cost | $777,016 | $861,400 |
Loans with interest only repayments tend to have higher rates compared to principal and interest. As you can see, with the same scenario for both repayment types, there’s a stark difference between the repayments and the total interest paid over the life of the loan.
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.
If you’d like to know more about your home loan options, get in touch with the friendly lending specialists at loans.com.au. Get in touch by calling 1300 183 284 or arrange a meeting at your convenience. Our lending specialists are more than happy to discuss your lending needs and find the perfect finance solution for you.
Disclaimer: The information provided in this article is general in nature and does not constitute financial or legal advice. Please seek professional advice tailored to your circumstances before making any financial decisions.
Find out in under 2 minutes if you qualify for one of our low rate home loans.
About the article
As Australia's leading online lender, loans.com.au has been helping people into their dream homes and cars for more than 10 years. Our content is written and reviewed by experienced financial experts. The information we provide is general in nature and does not take into account your personal objectives or needs. If you'd like to chat to one of our lending specialists about a home or car loan, contact us on Live Chat or by calling 13 10 90.
