What’s the difference between interest only vs principal and interest on home loans?

If you’re in the market for a new home loan or refinancing an existing mortgage, it’s important to understand how you intend to manage your repayments.

Home loan repayments can be made on either a principal and interest or interest only basis. If you opt for principal and interest repayments, each month you’ll pay interest on your loan as well as a portion towards the principal (the amount borrowed). This will see you gradually paying down your loan over time.

If instead you choose to make interest-only repayments, you’ll only pay your monthly interest charges, and your loan principal will remain the same. This option can be more affordable but won’t get you any closer to paying off your loan.

In general, lenders will only allow borrowers to make interest-only repayments for a certain amount of time before switching over to principal and interest repayments. Typically, owner occupiers can make interest-only repayments on their home loan for up to five years, while investors may have up to 10 years.

Why choose a principal and interest home loan?

While choosing to pay principal and interest on your home loan may be the more expensive monthly repayment option, there are a number of significant benefits to consider: 

• Pay off your home loan sooner – By paying down the principal on your home loan, you’ll increase your own equity stake in the property and eventually own it outright. This can be of particular significance to owner occupiers who plan to live in their home long term.
• Pay less in total interest – Chipping away at your principal amount will likely mean paying less in total interest charges over the life of the loan than if you were to opt for interest-only repayments. This is because interest is charged as a percentage of your balance.
• Pay lower interest rates – Borrowers who pay principal and interest on their home loan may also enjoy lower interest rates than those paying interest only, which can again contribute to paying less interest in total. 

Why choose an interest-only home loan?

The key benefit that incentivises some borrowers to choose interest-only repayments is that they are more affordable. But the reasons these borrowers may have for choosing this option can vary greatly, including the following:

• Investors seeking cash flow – Property investors may choose to pay interest only as a way to boost cash flow while still benefiting from capital growth.
• Investors seeking tax benefits – If the property is rented out, investors can typically claim the entire interest amount as a tax deduction. Which, in this case, would be the entire repayment amount.
• Homeowners wanting (or needing) to renovate – Some homeowners may switch to interest only repayments to free up some extra cash to cover the cost of a home renovation project. This could also be necessary if urgent repairs come about, either on an owner occupier’s home or an investment property.
• Homeowners needing to reduce expenses – If your budget is strained due to a change in circumstances, such as reduced or lost income or unexpected expenses, you could opt for interest-only repayments to make them more manageable for a period of time and reduce financial stress.

How to choose between interest only and principal and interest

Ultimately, the best choice for you will depend on your personal circumstances. It’s important to weigh up the pros and cons for both options before making your decision.

If you’re looking for advice specific to your financial situation, consider reaching out to a mortgage broker.

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