In a principal and interest home loan your repayments are divided into two portions:
- Principal - the amount you borrowed to buy the dwelling and;
- Interest - the amount the lender charges you for the loan.
On the other hand, an interest only loan sees you only pay the interest owed on the loan for a specified period of time which means you never reduce the principal. Put simply, if you had an interest only loan indefinitely, you would never pay off your home loan.
There are a number of reasons why you may choose to take one avenue over the other and while there is no such thing as the ‘best loan’, there is something to be said for paying down your principal and interest from the start. Take a step back, consider your current life stage and what your short and long-term goals are before deciding which loan is best for you.
Generally speaking, interest-only loans are popular among investors and first home buyers. These loans are more flexible as they typically carry lower monthly repayments and free up your cash-flow which you can use for other investments. Interest-only loans may also offer potential tax benefits to investors.
The flip side to an interest-only home loan product is that you could be in debt longer as you are only paying interest and not chipping away at the principal loan amount. Moreover, you may not be able to build equity because you are not paying down the principal. Unfortunately, if the property’s value depreciates during the interest-only period, you may end up owing more. In recent times, interest-only loans have become increasingly difficult to secure as lenders have had to adhere to strict benchmarks from Australia’s banking and financial services regulator.
Principal & interest
One of the benefits of a principal and interest loan is that while your monthly repayments may be higher to begin with, they will lower over the life of the loan. In addition, principal and interest loans typically carry a lower interest rate.
Lenders calculate your monthly repayments based off your loan term and the minimum repayments you need to make in order to pay the loan off by the end of the term. For this reason in a principal and interest loan, if you increase the amount or frequency of your repayments, you have the opportunity to get out of debt sooner and own the dwelling faster.
Aussie borrowers are currently benefiting from the lowest interest rates in decades so if you want to take advantage of the low rate environment and pay down your home loan faster, a principal and interest loan could be the right option for you.
What’s the right loan for me?
As you can see, there are pros and cons to both loan types and the right decision for you will depend on your unique financial situation and goals. If you want to check whether you might benefit from switching from principal and interest to interest-only or vice versa, use our home loan calculator.
If you’re unsure whether you should choose a principal and interest loan, speak to your local Mortgage Choice broker who will take the time to assess your needs and goals and compare home loan products from over 20 different lenders to find a suitable loan for you.