When applying for a home loan (or mortgage), there are many things to consider but one of the most important is how you will repay it. Generally, there are two types of home loan repayments to choose from: principal and interest repayments and interest-only repayments. It’s important to understand these different types of repayments and how they work when comparing home loans.
In this article, we’ll take you through what a principal and interest home loan is, how they work, and the pros and cons you might want to consider.
What is a principal and interest home loan?
A principal and interest (P&I) home loan is where you repay the principal amount and the interest charged on it over an agreed period of time (the loan term) — usually 25 years or 30 years.
A quick rundown
- The principal is the amount you borrow from your bank or lender when you take out a home loan.
- The interest is the cost of borrowing the principal amount from your bank or lender. The amount of interest is dependent on the interest rate charged on your home loan and how much money you borrow.
According to Moneysmart, most Australians take out a principal and interest home loan when buying a house or property. Some of the benefits of this type of home loan is that you reduce the amount of interest over the life of the loan, get to build equity, and own your home sooner compared to an interest only loan.
Principal and interest vs. interest-only home loans
As we mentioned earlier, there are two types of mortgage repayments you can choose from. While we’re focusing on principal and interest loans in this guide, it’s important to give a rundown of interest-only loans to help you work out which one is right for you.
An interest-only loan is where you only repay the interest (plus any ongoing fees) on the amount borrowed for a set period of time. During this interest-only period, usually up to five years, the principal amount remains the same unless you make extra repayments. This means the repayments on an interest-only loan are small to begin with.
This type of loan is commonly associated with property investors as they can claim higher tax deductions on the interest payments. They can also be beneficial for investors who are looking to sell their investment property after the value rises. Plus, with lower repayments, investors can boost their cash flow.
Interest-only loans can also be a suitable option for other types of borrowers including first-home buyers. The lower repayments can help those looking to manage their budget or are on a reduced income. However, it’s worth mentioning that during the interest-only period, you don’t build equity as the principal amount remains the same.
If you want to find out the difference in costs between the home loan repayment types, check out Moneysmart’s handy calculator.
What are the pros and cons of principal and interest home loans?
Here are some of the key pros and cons of principal and interest home loans you might want to consider:
- Pay less interest: One of the key advantages of principal and interest home loans is that you pay less interest overall than with an interest-only loan. This is because as you pay off both the principal and interest, you are also reducing the interest over the life of the loan.
- Building equity: As you are making larger repayments than you would with an interest-only loan, you are building your property’s equity. Plus, you can get full ownership of your property sooner.
- Lower interest rate: Generally, principal and interest home loans have lower interest rates than interest-only loans. This is often because you are seen as a less risky borrower than if you were only paying interest on your home loan. However, remember that interest rates can be subject to change so always make sure to check with your lender what the current rate on the loan product is.
- Principal amount isn’t tax deductible: Only the interest charges on a principal and interest home loan are tax deductible. If you’re looking to invest in your home, it might be worth looking into interest-only home loans instead to take advantage of tax deductions.
- Repayments are generally higher: Generally, the repayments are higher than an interest-only home loan as you are paying both the principal and interest from the start of the loan term.
How do I compare principal and interest home loans?
If you’re comparing principal and interest home loans, there are a few factors to consider. One of the most important to look at is the interest rate. Generally, you want a low interest rate but keep in mind that it can change depending on what type of rate it is. Before choosing a loan product, check with your bank or lender if the interest rate will remain the same or change.
Another factor you’ll want to keep an eye out for is the fees. Depending on which home loan you get, there are many fees you might be charged including application, ongoing, and settlement fees. Before purchasing a home loan, have a look through the Product Disclosure Statement (PDS) to understand what fees you’ll be charged.
Plus, compare the features that are included in the loan product. Some features in home loans can include an offset account, line of credit, or redraw facility which allow you to access extra repayments. They can make your home loan more expensive so make sure to weigh up if they’re worth it and whether you will actually use them.
More helpful info on home loans
Here at Oiyo, we want to help make your financial decisions a lot easier with our range of articles and easy-to-read guides. Buying a home is one of the most important financial decisions you’ll make in life. From an explainer on mortgage offset accounts to a handy moving house checklist, we’ve got plenty of helpful information on home loans.
Oiyo is a consolidated online resource, we are not financial advisors. We work with a range of industry professionals and compliance check our articles to ensure factual accuracy. However, we do not provide professional financial advice. Consider seeking independent legal, financial, taxation or other advice to check how the information and ideas presented in this article relate to your unique circumstances.