How to choose between interest only and principal and interest repayments
Which loan is the right one for you?
One of the biggest decisions a homebuyer or investor needs to make is what type of loan to have on their property.
In years gone by, the vast majority of people chose principal-and-interest loans, believing that the key to financial freedom was paying off their home loans regardless of whether they were owner-occupied or investment properties. Your parents probably taught you to get a good education, get a good job, buy a home and slowly pay it off. Remember that? However, these days, borrowers are becoming more educated about their finance options.
There are good reasons why most investors choose interest-only loans and why home owners often choose principal-and-interest loans. To help you understand the key differences, it's important to be familiar with the basic mechanics of how each loan works. As an example, let's take a look at a $400,000 home loan, with an interest rate of 5%, and then compare the differences between the two loans.
Interest-only loans are the easiest to calculate, given we simply multiply $400,000 by 5%, which equals an annual interest bill of $20,000 that can be paid back either weekly, fortnightly or monthly. If you repay it monthly, this would be $1,666.67 worth of interest per month. Of course, it's important to understand that by paying interest-only, you never actually pay down the principal loan amount. Instead you're just covering the interest component.
Principal and Interest
Calculating principal-and-interest repayments is a bit trickier because it involves paying off the loan in its entirety over a 25- or 30-year period. If we use a 25-year repayment timeframe as an example, then there will be 300 months in which you need to make a payment on the principal and interest.
If we look at the $400,000 mortgage again over a 25-year period, the first of the 300 monthly loan repayments would be $2,338.36. That’s $671.69 more than an interest-only loan. The extra you are paying goes towards slowly reducing your principal, which is the amount you owe on your loan. Each month, the amount of the principal you are paying off is slowly getting greater and greater, until the very last repayment is technically all principal and no interest.
If we take a look at the same scenario but increase the term of the principal-and-interest loan to 30 years, then the monthly repayment is slightly less: $2,147.29. This includes an even smaller amount of principal because you’re paying it off over a longer term.
So with a principal-and-interest loan, ideally you'd want to pay it off sooner rather than later as it will reduce the total amount of interest that you'll end up paying the lender. Some people do this by paying extra lump sums off their loan, while others find by making fortnightly rather than monthly payments, they sneak an extra payment in each year and this pays down the loan just that little bit sooner.
Obviously, if you have an interest-only loan, you are not paying off the principal at all and are not making any progress towards repaying your loan. However, in the case of a loan against an investment property, many investors prefer to pay interest only because the lower repayments leave them more cash for other purposes such as repaying their home loan or putting money in an offset account and eventually using the extra cash as the deposit for their next investment property. Of course, as only the interest component of your investment loans is tax deductible, it may make sense to maximise this tax benefit.
What about home owners?
Now contrary to normal financial advice, I’d also recommend home owners consider an interest-only loan. In my mind, it’s better to use the surplus cash from the lower loan repayments to service the debt on a well-located income-producing investment property that grows in value. To me, this makes more sense than waiting until you’ve paid off your home before buying an investment property. In time, both your home and your investment property will grow in value and the original mortgage will be a smaller proportion of the total value of your property. Once you’ve built an asset base of a number of investment properties, it’s worth switching to a principal-and-interest loan so that you slowly repay your debt to lower your loan to value ratios.
Whether an interest-only or a principal-and-interest loan is the right one for you, it's important to access all the information and support you need so you can make an educated choice that will benefit you over the long term.
Michael Yardney is a director of Metropole Property Strategists, which creates wealth for its clients through independent, unbiased property advice and advocacy. He is a best-selling author and one of Australia's leading experts in wealth creation through property, and he writes the Property Update blog.