Principal and interest vs interest-only loans
Lower home loan repayments might sound very tempting, but are interest-only home loans the right option for you? In this article, we’ll compare principal and interest versus interest-only loans and look at the pros and cons of each.
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Principal and interest vs interest-only loans: Pros and cons
What is an interest-only loan?
An interest-only home loan works the same way as a principal and interest mortgage for most of the term. Still, the lender agrees to allow a limited period where you only repay the interest accrued.
How do interest-only loans work?
You only pay interest during the interest-only term, so your repayments are lower than they would be if you were repaying the principal, too.
When the interest-only period ends, you return to paying down both the interest and the principal (the original borrowed amount). That means repayments on interest-only home loans are initially lower, but they end up being higher than principal and interest mortgage repayments once the interest-only period ends.
Interest-only home loans: Pros and cons
What are the advantages and disadvantages of an interest-only home loan?
Pros of interest-only home loans
- The primary advantage of an interest-only loan is that you enjoy a period of lower monthly repayments.
- Investors may benefit from the higher tax-deductible element of an interest-only home loan.
Cons of interest-only home loans
- Interest-only home loans leave you a lot more vulnerable to negative equity for a longer period than principal and interest mortgages.
- You’ll build no equity during the interest-only period unless the value of your property increases.
- When your home loan returns to normal, you’ll pay more than if you’d started repaying the principal loan from the start.
- Interest rates for interest-only loans are generally higher.
- When the interest-only period ends, your repayments are higher than with a principal and interest loan.
Interest-only home loan FAQs
Here are the answers to frequently asked questions about interest-only home loans.
How to calculate interest on an interest-only loan?
You can use Moneysmart’s interest-only mortgage calculator.
How long do interest-only loans last?
You can arrange for an interest-only repayment period of up to five years as an owner-occupier, and investors can sometimes get longer terms.
What happens when an interest-only loan expires?
When the interest-only period expires, your home loan switches back to a principal and interest setup. That means you start paying down the principal, plus any interest you’ve been accruing.
What banks offer interest-only loans?
Most of the major banks and many independent lenders offer interest-only home loans.
Are interest-only loans a good idea?
That depends on your situation and objectives. They work well for many property investors. They can also get owner-occupiers out of a temporary fix – for example, if they’re between jobs or experience a major life event like pregnancy or illness. It’s essential to get appropriate financial advice whenever you make a big decision, like choosing a mortgage.
What are the criteria for an interest-only mortgage?
Lenders differ, but you’ll generally need to have a good borrowing history, be able to afford repayments comfortably, and have at least 10% of the home’s value saved for a deposit. Some lenders will insist on a 20% deposit.
How much can you borrow on an interest-only mortgage?
The amount you can borrow using an interest-only loan will depend on how much deposit you have (most lenders will only look at interest-only home loans with a maximum LVR between 80 – 90%). Home loan providers also base lending decisions on your income, spending, credit history, and other factors like how stable your employment is.
Can I change to an interest-only mortgage?
Most lenders let you switch from principal and interest to interest-only repayments, but you’ll need to be able to demonstrate either a viable financial strategy or have a good reason for doing so. That could be because you plan to renovate, start a family, or because you can’t work for a period due to injury or illness, for instance. Don’t forget; you might need to pay early termination fees on your existing loan, plus setup fees on the new one.
When should you use an interest-only mortgage?
That depends, but you could use one to enable renovations on an investment property. Once you’d completed the work, you could then ‘flip’ the home for a profit, pay off your mortgage faster, and end up with more cash than when you started.
Why interest-only loans for investment properties?
If you’re a landlord, an interest-only investment loan may be a good idea because, ultimately, you’ll pay more interest during the life of the loan. Interest is tax-deductible so that interest-only home loans can prove a viable part of a broader taxation strategy.
Can you refinance interest-only loans?
Usually, yes. If you switch lenders, that will depend on whether or not you meet their qualification requirements.
Is it worth overpaying on an interest-only loan?
Paying down some of the principal can be worthwhile during the term. It builds equity, reduces the total cost of the loan, and makes you less vulnerable to negative equity, too. It can also be beneficial to have a line of credit in your home loan or a redraw facility.
How to calculate interest-only loan payments?
The easiest way to do this is to use an online interest-only home loan repayment calculator.
What is an interest-only home equity loan?
An interest-only equity home loan is a facility where the lender allows a line of credit based on a portion of your positive equity. They’ll usually let you borrow up to the point where your LVR reaches 80%. Many homeowners and investors use an interest-only equity loan to finance renovations or improvements.
Are interest-only loans tax deductible?
Yes, because you’ll only be paying interest, the entire repayment is tax-deductible.
Why would you choose an interest-only mortgage?
There are many reasons why borrowers choose an interest-only mortgage, including:
- Carrying out renovations on owner-occupied dwellings.
- Renovating or extending an investment property.
- Periods of illness or injury.
- Investors benefit from a higher tax-deductible loan element.
What are principal and interest loans?
Principal and interest loans are a type of home loan where you pay down a portion of the interest the lender charges, plus some of the original amount you borrowed each time you make monthly payments. Interest-only repayments don’t pay down any of the loan principal, just the interest charges.
How do principal and interest loans work?
You borrow a set amount of money over an agreed period – usually between 25 and 30 years, but it can be shorter. The lenders charge an interest rate, so each monthly repayment you make reduces the loan amount and pays some of the interest off.
Principal and interest home loans: Pros and cons
Here are some of the positive and negative elements of a principal and interest home loan.
Pros of a principal and interest home loan
- Principal and interest repayments are more consistent than with interest-only loans.
- You pay less interest throughout the entire mortgage than with an interest-only loan.
- Start building equity from day one.
- Fewer risks associated with negative equity and falling house prices.
Cons of a principal and interest home loan
- Higher repayments than during an interest-only period.
Principal and interest loan FAQs
Still have some questions about principal and interest home loans? Find the answers you need here.
How to calculate principal repayment home loan?
The easiest way to figure out your principal interest loan repayments is to use an online principal and interest loan calculator. You can adjust the loan amount, term, and interest rate to match different lender products and offers.
How to find the principal amount of a loan?
The principal amount of your home loan is initially the amount you borrowed, and during the term, it’s the loan’s outstanding balance.
Can you pay the principal on an interest-only loan?
Not automatically, until the interest-only period ends, you’ll begin to make principal payments again when the home loan returns to normal. You can make voluntary payments toward the principal at any time, however.
What is better principal and interest or interest-only?
That’s going to depend very much on your specific goals and financial situation. For some borrowers, an interest-only period is necessary; for others, it just works well for their cash flow and investment ambitions. Some borrowers will benefit greatly from avoiding interest-only home loans altogether and building equity in their home from the start.
How is the principal amount of an interest-only loan repaid, and why is my interest higher than my principal?
Mortgages use what’s called an amortising payment schedule. That means your repayments stay the same for the duration of the loan term, but the ratio of principal and interest you pay changes. At the start, you’re paying less of the loan balance down but more in interest, and as the loan progresses, the interest portion falls while the amount of principal you repay rises.
Is it better to refinance or pay extra principal?
It depends on your goals. When you switch to a mortgage with a lower interest rate, you’ll achieve slightly lower repayments, but you’ll still generally have a similar loan term ahead of you. Refinancing can also actually create a situation where there’s less motivation to make extra repayments against the loan balance – or there’s certainly less reward for doing so. If your primary aim is to get out of debt quicker, you might be better off paying down the principal faster. Refinancing won’t change that situation.
What happens if I pay an extra month on my mortgage?
A couple of things will happen. Firstly, you’ll reduce the loan principal and lessen the total cost of your home loan – because you’ll ultimately pay less interest over the life of the loan. Secondly, you’ll build some equity in your home. If you have a redraw facility, making extra repayments also means you can access that cash later down the line.
Is it better to get a 15-year mortgage or pay extra on a 30-year mortgage?
That depends on your income and expenses. If you can comfortably afford to repay your home loan in half the time, the amount of interest you pay will be a lot less.
Is it wise to pay off a mortgage early?
Nearly always. All borrowing costs money, and when it makes sense to do so, you should look to pay off your mortgage as soon as possible. The longer you borrow, the more interest you pay
Do extra payments automatically go to the principal?
Usually, yes. Some lenders might use them toward fees or interest first, so it’s best to check with your specific home loan provider and make it clear you want to prioritise paying down the principal.
How can I lower my monthly mortgage payment without refinancing?
One good way to do this is to make extra repayments throughout the year. If you don’t want to do that with lump sums, you can change your repayment schedule to weekly or fortnightly. Let’s say your monthly repayment is $4000. Breaking that up into four weekly payments makes each one $1000. The difference here is that instead of making twelve monthly payments of $4,000 each year ($48,000), you’ll be making fifty-two payments of $1,000 ($52,000) instead. That reduces the loan amount faster and makes payments lower.
Should I pay off my mortgage or invest the money?
That’s a potentially complex question and one that has many different answers depending on who you are and where you’re at. Paying off your mortgage will save you a principal and interest repayment every month, which means you’ll pay no more interest on your home loan. Investing the money will also get you a return, depending on how you invest the cash. Weigh up the potential investment return against the saving on your mortgage interest rate and begin to decide from there. Remember to factor in any lender break fees that apply.
Disclaimer: This is a general guide only and is not intended as a substitute for financial advice.
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