Interest only versus principal and interest repayments

Different loan repayment types

When you apply for a home or investment property loan, you may have the option of one of these repayment types:

• principal and interest repayments
• interest-only repayments

It’s important to understand how these different types of loan repayments work and how they can change over time. Each have their advantages and disadvantages.

What is the loan ‘principle’ and what is the ‘interest’?

Your home loan is made up of two parts: the loan principal and the interest.

The loan principal is the amount you borrow to fund your property purchase. This is the difference between the full cost of the property and your deposit.

The interest is the amount you're charged by the lender for borrowing the principal amount.

Here’s what you need to know about the two most common types of loan repayments.

Principal and interest repayments

If you have this type of home loan, you’ll need to pay both the principal as well as the interest charged on it.

To begin with, you’ll mostly pay interest. But as time passes and you chip away at the loan, you’ll start paying a greater percentage of the principal.

Advantages of a principal and interest loan

• pay less interest over the life of the loan
• pay a lower interest rate compared to interest-only rates for an equivalent home loan
• pay off your loan faster, so you'll own your property outright sooner.

Disadvantages of a principal and interest loan

• repayments are higher than interest only
• may not be as tax-efficient for investment loans.

Interest-only repayments

This is when you only pay the interest portion of your loan for a set period (usually the first 5 or 10 years). Once the agreed interest-only period ends, you’ll start repaying your principal at the current interest rate at that time.

As you’re not making payments on the ‘principal’, this will remain the same, unless you choose to make additional repayments.

There are two ways you can do this. You might pay it off each month (in arrears), or once a year (in advance). ‘In arrears’ is usually at the end of each month; ‘in advance’ is in that year’s first month.

If you’re investing in property, paying interest in advance could help bring forward tax-deductible interest payments (which may reduce your taxable income). As always, it's a good idea to run this past your accountant first.

While interest-only repayments are lower during the interest-only period, you’ll end up paying more interest over the life of the loan.

There are also risks involved with getting an interest-only repayment loan. For example, if your home or investment property declines in value during the interest-only period, you could come out with no equity. Meaning, you may end up owing more than the property is worth.

Australian Securities and Investments Commission has some useful information if you’re interested in using an interest-only repayment period as part of the loan term. Check out their MoneySmart, opens in new window guidance for some easy to follow infographics about the pitfalls and benefits of this type of lending structure.

They also have examples of how much you can expect to pay for this type of loan.

Advantages of interest-only loans

• lower mortgage repayments for a limited time to suit your lifestyle (e.g. taking time off work to be a primary carer)
• possible tax benefits for investment loans.

Disadvantages of interest-only loans

• principal amount will not reduce during interest-only period
• higher repayments once the interest-only period finishes
• higher interest rate during interest-only period
• more interest payable over the life of the loan.

Case study of two loan repayment types

See how the two types of loans affect John and Rebecca's repayments.

John and Rebecca have a loan of $500,000 and are deciding which repayment option is suitable for them.

The table shows the difference in interest they will pay over the life of their loan.