Principal and Interest vs Interest only - Which should you choose?
When you take out a loan with a bank or lender, you have two kinds of repayment options – principal and interest or interest only (occasionally there is a third option, Interest In Advance, but we won’t talk about that here). The principal of any loan is the amount you borrow, while the interest is what the bank charges the customer to borrow the principal. Because interest compounds over time, this can equate to hundreds of thousands of dollars over the life of the loan.
Most of the time, in my opinion, people should be making principal and interest repayments off their loan. The faster you can pay down your debt and build equity in your home, the more choices you’ll have such as concentrating on paying off the loan, renovating or using the equity to invest in property or shares.
Interest only loans have the potential to cost you a lot more money in the long run. For example, if you secure a $500,000 home loan over a 30-year period, and pay interest only for the first five years, you will still owe $500,000 and only have 25 years to repay the principal and interest. That means the five years of interest only payments are gone, and your repayments will be potentially much higher for the remainder of the loan term.
Since the Royal Commission into the banking and finance industries, it has become almost impossible for owner-occupiers to secure 100% interest only home loans. And that’s a good thing.
When are interest only repayments a good idea?
For specific types of buyers such as property investors and developers, interest only loans can be a useful financially strategic option. Let’s look at a few reasons why:
Lower monthly repayments
If cash flow is important, which it often is for developers, keeping loan repayments to a minimum is a key consideration of any loan. For example, the monthly principal and interest repayments on a $400,000 loan at 4.5% over 30 years is $2,027, while an interest only repayment is $1,500. That extra $500 per month can be very handy.
Property investors and developers can claim the interest portion of any repayments as a tax reduction in their tax returns, so paying interest only on the mortgage can maximise those deductions. If they were paying down the principal, then the interest would reduce and their tax deductions would decrease. The goal for any investor is to grow the value of the property and maximise their tax deductions before selling and making a profit.
When are interest only repayments a bad idea?
While interest only repayments can be beneficial for some types of borrowers, it still has its cons as well:
- The loan still needs to be paid off eventually, and depending on the length of the interest only period, the ongoing principal and interest repayments can be high and cause financial stress.
- We are going through a period of falling house prices. Therefore, the danger is that at the end of the interest only period, the property could be worth less than the amount owing. That severely limits your options, especially if you have to sell.
- Interest rates are still incredibly low, so unless there is a financial incentive to pay interest only, it’s a great time to pay down the principal as fast as possible.
What to do if you’re considering an interest only loan?
If you’re considering an interest only loan, you should definitely seek the professional advice of your accountant. They can explain the pros and cons for your particular situation, and crunch the numbers to give you an educated idea of any financial benefits from such an investment strategy.
After speaking with your accountant, talk to your mortgage broker about the type of loan product you need. They can then source the right product for your particular set of circumstances to ensure you save as much money as possible and have a loan that suits your goals.
Book a no obligation appointment with me by filling out the contact form on the right and remember my service is no cost to you, as I’m paid by the lender you choose. At the end you’ll know exactly where you stand and what you can do. Knowledge is power, so make sure you have it.