There are many things to think about when applying for a home loan, but one of the most important is the interest you’ll pay on what you borrow. What many don’t realise is that the type of repayment you choose will have a major effect on how much interest you pay over the life of the loan.
When you apply for a home loan, you have the choice between interest-only repayments and principal and interest repayments. With principal and interest, your repayments go toward both the principal – the amount you’ve borrowed – and the interest charged. With interest-only, repayments only count towards the interest charged on the loan.
Each option has its benefits but will also have a big effect on the interest you pay on your home loan. Let’s take a look at the difference between the two types and what they could mean for you.
When you make a principal-and-interest repayment, the money does two things – it reduces your principal and pays the interest your lender charges.
This means every principal and interest repayment reduces the amount you borrowed to purchase the property, which is what your lender charges you interest on. Of course, this also means the amount of interest you’re charged on what you borrowed reduces with every repayment.
There are 3 main benefits of this repayment type. First, choosing principal and interest repayments will help you own your home sooner, as you’re always repaying the money that you’ve borrowed.
Second, principal and interest repayments mean you will pay less interest over the life of the loan than with an interest-only loan. This makes the cost of the loan lower for you.
Finally, the interest rate on principal and interest repayment loans is usually lower than on interest-only loans, which again reduces the amount of interest you’ll pay over the life of the loan.
In short, principal and interest repayment home loans are more cost-effective than the alternative.
With interest-only repayments, you only pay the interest charged on the amount you’ve borrowed on your home loan. This means that repayments don’t reduce the principal, which results in higher interest charges over the life of the loan.
Usually, interest-only repayments last for a set period (5-10 years, for example), after which the loan switches to principal-and-interest repayments.
Interest-only repayments have many benefits. For a start, the repayment amount is usually cheaper than a principal-and-interest loan during the initial interest-only period. This can be useful if you need to limit what you’re spending for a while. It might also be useful if you have several investment properties and want to minimise what it costs to maintain their mortgages.
Interest-only loans may also provide tax benefits. Given that interest paid on a mortgage is tax deductible for a rental property, all repayments on an interest-only loan could potentially be claimed as tax deductions. Please see your tax adviser to see if these benefits apply to you.
While these are obvious benefits for investors, there are also many downsides to interest-only home loans. For a start, interest-only loans usually come with much higher interest rates. Once the interest-only period ends, your repayments will also need to cover both the interest and the loan principal, which won’t have changed since the loan term began. This means your repayments are likely to be much higher after the switch to cover the principal as well as the interest.
The fact that you’re not paying the principal down during the interest-only period also means you’re relying on growth in the value of your property to build equity (which is the difference between what you owe and what the property’s worth). All of these things are essential to keep in mind when considering an interest-only loan.
Basically, you pay different amounts of interest on each loan type.
For example, imagine you get a home loan of $500,000 with a term of 30 years.
If you opt for interest-only repayments with an interest rate of 5.95% p.a. in the first 5 years, you will repay $1,149 each fortnight over that time. Once the interest-only period ends, you switch to principal-and-interest and your repayments increase to $1,484 per fortnight over the remaining 25 years. The whole loan costs you $1,113,666 over 30 years.
If you instead choose principal-and-interest over 30 years, you will repay $1,380 each fortnight. Your total loan cost will be $1,076,496 – that’s $37,170 less interest than with an interest-only loan.
Each of these examples assumes you don’t sell your home and repay the mortgage before the end of the loan term. If you’re an investor, you might choose interest-only to take advantage of lower repayments and possible tax deductions. You might then choose to sell the property shortly after the interest-only period finishes and benefit from any capital gains the property has made in the meantime (subject to possible Capital Gains and Land Tax).
Rather than choosing a repayment type based on the interest rate or repayment amount, first work out what you want to achieve. If you intend to invest and sell before the loan term ends, interest-only might be useful for you. On the other hand, if you’re buying a family home for the long term, principal-and-interest repayments might serve you better.
Don’t forget – if your financial goals change, you can always talk to us about what we can do to support you with your next move.
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This information is general in nature and has been prepared without taking your objectives, needs and overall financial situation into account. For this reason, you should consider the appropriateness of the information to your own circumstances and, if necessary, seek appropriate professional advice.