Principal and Interest
Signing up for a home loan – or more precisely, the regular repayments - can be daunting, which leads many buyers to consider an interest only loan instead of one that covers both principal and interest. Interest only loans can also be incorporated into a property investment strategy.
A principal and interest loan (P&I) requires you to make repayments on the cost of the house as well as the interest. For example, you may borrow $400,000 to purchase a property and sign up to a 5% interest rate for a period of 30 years. Your monthly repayments will cover the principal as well as the interest and will be approximately $2150.
With a P&I loan, the amount of money you owe on your house diminishes over the period of the loan, until you have fully paid it off.
An interest only (IO) loan only requires you to pay off the interest. In the same scenario as above, your monthly repayments would only be around $1600.
While this looks like a significant saving, the amount you borrowed will not be reduced as you are only paying off the loan interest, and not the principle loan amount. If you pay off the entire interest amount, the property will still not belong to you. You will only benefit if the value of the property increases since you made the purchase.
Making repayments that include principal as well as interest means that eventually you will own every last brick and tile of your home. This will enable a mortgage-free life or empower you to invest and build a wider property portfolio.
Many property buyers decide that the higher monthly cost of paying both principal and interest is worth it for the financial freedom and flexibility in the long term.
When you take out an interest only loan, you are relying on the idea that your property will increase in value.
So if you buy a $400,000 property and pay interest only for five years, if the value goes up 10% by the time you come to sell, then $40,000 of the sale price goes into your pocket (less taxes depending on your specific situation).
Interest only loans are chosen by many who are investing in property as a wealth building strategy because it involves cheaper repayments. They are also likely to be able to claim tax deductions on these interest based payments, making it worth their while. Paying IO can be a savvy strategy for those who invest in property that significantly increases in value over a short time.
Home loans are anything but a one-size-fits all solution. Making the choice between IO and P&I depends on your exact circumstances, your property dreams and your budget. Now that you understand the difference between these types of repayments, you”re better informed to make the best decision with the help of your lender.
Use our handy calculator to find the difference between an interest only and a principle and interest loan so you know what your commitment will be.