Understanding home loan repayments:
Principal and interest vs interest-only
Last updated: 22 May 2024 | Estimated read time: 4 Minutes
When it comes to repaying your home loan, you have two options – principal and interest, or interest-only. Here’s what you need to know about each.
Home loan repayments can be a big drain on the monthly budget and the thought of reducing them, even for a short time, may be appealing. But before you opt for interest-only repayments over principal and interest, there are a few considerations to be aware of.
How do principal and interest repayments work?
There are two different parts to your home loan – the principal loan amount and the interest you pay on it.
Principal
Interest
When you get a new home loan or refinance, you may be given the option to repay the principal and interest at the same time, or just pay the interest for a set period – usually up to five years. Once your interest-only period has ended, you’ll generally automatically switch to paying principal and interest. Or you may be able to refinance to a new loan and a new interest-only period.
Choosing to pay just the interest on your loan can give you some short-term breathing space and could have tax benefits in some cases, but you’ll pay more over the longer term. Here’s why.
Principal and interest repayments
When you pay principal and interest, you’re paying off your loan amount as well as the interest costs. This means your loan will reduce over time. And because interest is charged as a percentage of your loan amount, as your loan reduces, so does the overall interest you’ll pay.
While your monthly repayments will be higher, many lenders offer a lower interest rate when you pay principal and interest than for an interest-only home loan, so you’ll pay less over the long term.
Possible
Advantages
- You’ll usually pay less interest over the life of your loan.
- You’ll usually pay a lower interest rate than an interest-only loan, saving you money.
- You’ll tend to pay off your loan faster.
Potential Disadvantages
- Your monthly repayments will typically be higher than an interest-only loan.
- If you have an investment loan, you may miss out on some tax benefits.
Interest-only repayments
When you choose interest only repayments, you’re not paying down your loan, so it doesn’t reduce over time. So at the end of your interest-only period, you’ll still have the same amount to pay off.
After your interest-only period has ended, you’ll need to switch to principal and interest repayments or refinance to a new loan.
Making interest-only repayments usually means that you’ll pay less in the short term, but you will end up paying more in interest over the full life of your loan.
Possible
Advantages
- Potential tax benefits if you have an investment property loan.
- Reduced repayments for the short term can help with cashflow or temporary life circumstances like taking time off work to start a family.
Potential Disadvantages
- You’ll pay higher repayments after interest-only term ends.
- You’ll pay more interest over the life of your loan.
- A higher interest rate applies during the interest-only repayment period.
Choosing between principal and interest vs interest-only repayments
There’s no single right answer. The best option for you will depend on your individual situation and financial goals.
An interest-only home loan typically has lower repayments at the outset, so it could be an option if you have a temporary need to free up more cash or if you want to take advantage of tax benefits for an investment property home loan. But keep in mind that you’ll likely pay more in the long run, including a higher interest rate for the interest-only period of your loan and then more interest over the long-term.
On the other hand, paying principal and interest on your home loan will usually mean that your repayments are higher at the start of the loan term, but you’ll pay it off faster in the long run – and pay less in interest overall. However, if you have an investment property, you may miss out on some tax benefits.
Contributor | Anthony Moir, Treasurer
Anthony joined Pepper Money in February 2021 as Treasurer. With over 25 years of experience in treasury and debt capital markets, he has worked with a diverse range of bank and non-bank lenders. Read more.
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