Home loan repayment types

What you’ll learn

• What interest-only repayments are
• What principal and interest repayments are
• The difference between these repayment options and the short and long-term cost implications
• How to calculate which might be better for you: interest-only or principal and interest

Home loan repayment options

When you apply for a home loan, you’ll need to choose the best repayment option for your financial situation.

There are two main repayment types to choose from:
 

• Interest-only
• Principal and interest

The difference between interest-only and principal and interest repayments

There are two parts to a home loan balance:

• The principal amount is how much you have borrowed.
• The interest is an amount your lender charges you based on your principal. It’s calculated daily as a percentage (your interest rate) of your principal and added to your balance every month.

If you choose interest-only repayments, you are only paying off one part of your home loan – the interest charges. Choosing principal and interest repayments means you’re paying off both parts of your home loan (and you’re paying off your home loan faster).

How interest-only repayments work

If you choose interest-only repayments, you’re only paying off the interest portion of your home loan, plus any fees. The total amount you have borrowed stays the same.
 

Interest-only is available for a set period of time after which you’ll automatically revert to principal and interest repayments.

Interest-only is available for 5 years if you’re an owner-occupier and up to 15 years if you’re an investor, subject to approval and eligibility criteria.

When you switch to paying principal and interest repayments, you’ll be repaying the amount borrowed as well as the interest portion of your loan. This means your fortnightly or monthly repayments will be higher.

It’s also important to note that the interest rate on interest-only repayments is higher than on principal and interest repayments.
 

Benefits of interest-only

• The temporarily lower repayments may suit your lifestyle and financial situation. For example, you may be able to use your cash flow to pay off debts or to take time off work to care for a loved one.
• If your loan is for an investment property you may be able to claim tax benefits, for example, higher tax deductions. 

What you need to know about interest-only

• The interest rate will be higher compared to the interest rate on principal and interest loans. This means you’ll pay more over the life of the loan.
• Interest-only is only available for a set period (and there may be a limit on the total amount of time you can pay interest-only over the life of your loan).
  
• When your interest-only period ends and you start paying principal and interest, your repayments will be higher than if you’d paid principal and interest from the outset. This is because the principal needs to be paid off in a shorter amount of time.
  
• You’ll build up equity more slowly during an interest-only period (equity is the value of your home less the amount you owe on it). If your home doesn’t increase in value, you won’t build up any equity. This could be a disadvantage if your circumstances change and you want to sell.
  

How principal and interest repayments work

Principal and interest repayments go towards paying off the amount you have borrowed (the principal) and the interest, plus any fees.
 

By the end of the loan term (which can be up to 30 years), you will have repaid the amount borrowed and the total interest owed. This means your home will be mortgage-free. 

Benefits of principal and interest

• Because you’re paying off both parts of your home loan, you’ll pay off your loan amount faster. With every repayment you are one step closer to owning your home outright.
• Principal and interest repayments have a lower interest rate. You’ll also pay less interest over the life of your loan. Over a loan term of 30 years, you could save a significant amount in interest.
  

What you need to know about principal and interest

• Repayments are initially higher than interest-only repayments (but remember that your repayment amount will be higher again after the interest-only period ends).
• If you are a property investor, the principal and interest repayments on your investment property might be less tax-efficient compared to interest-only repayments.

Case study: Interest-only versus principal and interest

In this fictional example, we’ll look at the difference between the total interest rates paid on the two different repayment types.
 

Armaan and Charlie are owner-occupiers with a home loan of $500,000 over a loan term of 30 years. They’re working out which is better for them: interest-only or principal and interest repayments.
 

They compare two options:

• Principal and interest with a comparison rate (this includes the general fees and charges) of 3.69% p.a.
• Interest-only with a comparison rate of 4.24% p.a. for the first five years of their mortgage.

Armaan and Charlie’s minimum monthly repayments
 

Armaan and Charlie work out that they could pay $308 per month less for years 1–2 of their mortgage payments and $229 per month less for years 3–5 if they choose interest-only. However, they note that this means they’ll need to pay $282 per month more for years 6–30 of their home loan. This means that they could pay $57,230 more over the term of their loan if they choose the interest-only option.
 

To sum up

The best repayment option for you is one of the big things you’ll need to think about when organising your home loan. Interest-only typically means your fortnightly or monthly repayments will be lower at first, but interest rates are higher than on principal and interest repayments and you’re likely to pay more over the life of your loan. There are pros and cons to both so it is important to take time to calculate which repayment type is better for you. You can use our home loan calculators or talk to someone at your local branch.
 

Calculate and compare your home loan repayment options and estimate the different interest charges with our handy home loan repayment calculator. Work out which is better for you: principal and interest or interest-only.