Principal and interest versus interest only

Before you look at specific products, it’s a good idea to take a step back and think about how you intend to pay off your loan.

The two main methods of repaying a home loan are making principal and interest payments, or paying interest only.

Principal and interest repayments

Paying off principal and interest means that there are two parts to your payment — the first is the repayment of the principal itself, the second is the interest accrued.

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.

Interest-only repayments

With interest-only repayments, you defer the repayment of your loan principal for a set period (usually the first 5 or 10 years). Once the agreed interest-only period ends, you’ll start repaying your principal.

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.

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.

There are risks involved with getting an interest only repayment loan. For example, if your 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.

We have a more detailed explanation and case study to help demonstrate the differences in our article interest only vs. principal and interest repayments

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 info graphics 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.

Construction loan

If you’ve decided to build your own investment property, then a building and construction loan (BICOE) could be the way to go. Here you’ll receive your loan in increments, meaning you can pay invoices as they come in.

A typical house construction scenario has five stages:

  1. Laying the slab.
  2. Roofing and tiling.
  3. The internals.
  4. Lock-up.
  5. The final payment.

Paying each bill as it comes in means you won't pay interest on your building costs until the work has been done.

For example - say you've had a $250,000 loan approved and the first invoice in is for the slab - $50,000.

If you draw down the full loan, you'd be paying interest on $250,000. But a construction loan let's your draw down just the money you need — in this case, $50,000.

You can do this again at the other stages of the project.

Remember if you've chosen an interest-only period, you won't have to pay off the principal during this period. This gives you better cash flow which is handy if you're renting while building.

Keep in mind that as you draw down more of your loan, the amount of interest you pay will start increasing and you'll need to budget for that.

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The information contained in this article is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, financial and taxation advice before acting on any information in this article.