July 25, 2017
With interest rates on Interest Only (IO) home loans now significantly higher than those on Principal and Interest (P&I) repayments, many of our customers are asking whether they should change to P&I repayments.
As background, the reason interest only rates are higher is because of rules introduced by the Australian Prudential Regulation Authority last year, requiring banks and lenders to limit growth in investor lending to 10 per cent a year, and reduce interest only lending to 30 per cent of new loans.
To limit this growth, banks and lenders have been increasing their interest rates on investor and IO lending.
What are interest only and principal and interest repayments?
Interest Only (IO)
Only the interest on the principal is repaid during a specific period of the loan, therefore repayments are lower than with a standard P&I loan. At the end of the interest only period, the borrower must start making principal and interest repayments over the remaining term of the loan.
Principal and Interest (P&I)
Principal and interest repayments cover all the interest plus some of the principal (i.e. the actual amount of the loan) so that the loan is gradually repaid over time. Initially, loan repayments comprise mainly of interest but as the principal gradually reduces the interest component will also reduce and the actual loan repayment accelerates.
Let’s look at an example
You’ve borrowed $500,000 on a 30-year Standard Variable loan to buy your home to live in. Here’s a comparison of what your monthly repayments may look like in the scenarios below:
In this example, for the first 5 years during the IO period, your monthly repayments will be lower. From year 6 once the IO period ends your monthly repayments will increase. Also the amount of interest you will pay over the life of the loan will be higher when taking the IO option.
To calculate loan repayments on a different scenario, try our Home Loan Repayments Calculator.
Things to consider...
Principal and interest repayments
You will be paying down your principal balance from your first repayment
You could pay less interest over the life of the loan as your principal balance reduces
Currently our interest rates on principal and interest repayments are lower than interest only.
Interest only repayments
Generally preferred by customers purchasing an investment property or a property that is expected to be used as an investment in future
Investors may be able to claim interest paid as a tax deduction if the loan is to purchase a residential investment property earning rental income
Interest only repayments should not be considered solely for lower repayments as interest only periods are limited. After the interest only period, your repayments will switch to principal and interest and your repayments will be higher. You may pay more over the life of the loan.
Speak to the experts
There are lots of things to consider when deciding which home loan and repayment options are right for you.
For professional home loan advice, call us today on 03 9432 6070 or contact us online at the top of this page.