Learn about one of the most basic details of your home loan and how to make use of it to pay your loan off quicker.
The phrase "principal and interest" is top of mind for many borrowers at the moment. Recent moves by the Australian Prudential Regulation Authority (APRA) have seen many lenders cut rates on principal and interest home loans while raising rates for interest-only borrowers. These rate moves have grabbed media attention, as lenders try to incentivise interest-only borrowers to move to principal and interest repayments.
If all that media coverage has you scratching your head, fear not: We're here to demystify principal and interest repayments for you.
Put simply, a principal and interest payment means your repayment is divided up into two portions. Some is sent towards paying off the interest due on your outstanding loan amount, while the remainder goes towards paying off the outstanding loan amount itself.
What does principal and interest mean? Principal is the amount of money you have borrowed from the bank (minus your repayments). Interest is the money charged on top of the principal and is calculated based on the interest rate and the size of the principal.
Why can the amounts of interest and principal I pay change over the course of my loan?
If you take out a loan in which repayments go towards both the interest and principal payments, you’ll notice most of your repayment will go towards interest at the beginning of the loan and only a small amount will go towards the principal.
Look at the two graphs below, based on a $250,000 loan at 5.70% p.a. over 25 years.
In the first month of repayments you’re paying interest on the whole amount you’ve borrowed, but as this amount is paid off over the years, the interest due is smaller.
But if you’re paying less interest and the principal is getting smaller, why are your repayments not getting smaller?
This is because your lender has worked out exactly how much you’ll need to spend on each repayment to pay off your loan in the term you’ve agreed to. The result of these calculations is called an amortisation schedule. The schedule shows how much of your payments go towards interest and how much goes towards principal payments and this will show that the amount that goes towards paying off the principal gets bigger as the years go on and does so at a faster rate.
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Can you pay ‘principal only’ or ‘interest-only’ payments?
Having a loan where a borrower only paid off the principal would mean that the lender wouldn’t be charging interest and therefore not making any profit.
Sometimes paying no interest is required. In Islam, Muslims are prohibited from ‘usury’ or unfair lending, which means they can’t pay a lender interest. In these cases loans which are principal only are available, although they might be a venture where the lender purchases the property and sells it to the vendor with a built-in profit margin from the start, or a rent-to-own contract.
Interest-only loans, on the other hand take away the amount you’d usually pay towards your principal with each repayment, meaning your repayments are smaller. They’re usually offered for a set amount of years and are popular with investors who want to maintain their cash flow. They also come with some tax benefits. However, these loans are becoming more difficult to obtain due to moves by APRA to cap new interest-only lending at 30%.
How can you pay off your loan faster?
Many borrowers choose to pay off their loan in a principal and interest scheme because it’s a quicker way to pay off your loan. There are even ways to accelerate this further:
100% offset accounts. An offset account reduces the amount of interest you pay, meaning more of your payments go towards the principal. This can save you thousands in interest and years off your loan.
Lump sum payments. Lump sum payments made on a loan at the beginning of the loan term will help pay it off faster. This is because a lump sum payment will pay off the interest due for the repayment and then put a much larger than usual payment towards the principal. As discussed above, the interest you pay is related to how much you still owe, so reducing this amount means you pay less interest and pay the loan off quicker.
Make bi-weekly repayments
If you switch your repayment frequency and make a repayment every two weeks, you’ll actually end up making an extra repayment each year. This is because there’s 26 fortnights in a year, which equates to 13 months of repayments. It may not sound like much, but on a principal and interest loan it could reduce your loan term by up to five years.
Why do we pay interest?
The short answer is a bank is a business and like any other business it wants to make a profit. The interest you pay is part of their profit.
To answer why the interest we pay fluctuates we first need to know where lenders get the money they lend from.
When you apply for a loan, your lender will source funds for you from a range of places.
According to the Reserve Bank of Australia (RBA) almost half of this now comes from the domestic market. This means some of your loan money will be made up of funds taken from other Australian’s savings and term deposit accounts.
The other portion is borrowed from wholesale lenders, which can be from sources such as superannuation funds or other investment funds looking for safe investments.
The more expensive it is for your lender to get a hold of this money the more interest you might have to pay. The cash rate set by the RBA each month also has a significant bearing on how much interest is paid. This is why your repayments can fluctuate each month.
If the RBA lowers the cash rate, it could become cheaper for lenders to source funds for loans and therefore lenders may lower their interest rates. It’s part of the reason why a continual comparison of the other loans in the market is always necessary.