When you apply for a mortgage, you have the option of choosing between a principal-and-interest (P&I) loan and an interest-only (IO) loan.
With a P&I loan, you simultaneously pay interest and pay off some of the outstanding loan (also known as the principal) when you make your repayments.
But with an IO loan, you pay nothing but interest when you make your repayments. As a result, your repayments are lower, at least during the IO period. At some point though, your loan reverts from IO to P&I, at which point your repayments rise.
Imagine, for example, you were taking out a $500,000 loan, with a 30-year term and a 6% p.a. interest rate.
If you chose the P&I option, your repayments would be $2,998 per month, or $1,079,191 over 30 years.
If you chose an IO loan that was interest-only for the first five years, your repayments would initially be less – $2,500 per month. However, when the loan reverted to P&I for the final 25 years, your repayments would be higher – $3,222 per month. (That’s because you’d now have 25 years to pay off the $500,000 principal, rather than 30 years.) Also, your total repayments over the 30-year term would be higher – $1,116,452.
The pros and cons of an interest-only loan
As with all finance products, there are trade-offs involved with IO loans:
- The upside is your repayments are lower during the IO period.
- The downside is your repayments are higher when the loan reverts to P&I and you pay more over the life of the loan.
- Another downside is the interest rate is usually higher for IO loans than P&I.
Three reasons borrowers may choose interest-only loans
Preserve funds. They have limited disposable income at the time they apply for the mortgage, but expect to have more in the future – for example when a new business takes off or one member of the household returns to work or a child leaves home.
Maximise tax benefits. Interest-only loans are popular with investors, because, unlike owner-occupiers, investors are allowed to claim a tax deduction for interest payments (but not principal repayments). They can then use the money they save to help fund the deposit on a future investment property.
Prepare for a future sale. If a buyer expects to sell the property in a few years, they may prefer to go IO in order to limit their expenses before selling.
As you can see, there’s a lot to weigh up when deciding between P&I and IO. But you don’t have to decide on your own. Your Loan Market broker can help you find the right loan for your circumstances.
