Principal and interest vs interest only loans
Which home loan type is right for you?
Choosing the right home loan can save you a significant amount of money over the life of your loan.
Whether you choose a principal and interest (P and I) or an interest only (IO) loan often comes down to your financial goals.
RACQ Financial Advocacy Analyst Nathanael Watts shares his tips on choosing between P&I and IO loans.
What is the difference between a P and I and an IO loan?
Principal and interest is the standard type of loan repayment for owner occupied loans which requires both the principal (amount borrowed) and the interest charged by the bank to be repaid in full.
Interest only is more common for investment loans and repayments will only cover the interest charged on the loan, without reducing the loan balance.
How do P and I loans work?
When you take out a principal and interest loan, you’re required to repay the principal amount and the interest charged by the bank.
Paying the P and I each month will reduce the balance of your loan until it is completely paid off at the end of the life of the loan.
As you make repayments on the loan you will reduce the amount of interest you are charged each month and build equity in your home, which can increase you borrowing capacity for future loans.
What is the advantage of P and I loans?
P and I loans will have stable repayment amounts, which allows you to budget your home loan expenses easily.
The repayment amounts will be influenced by interest rate changes. This must be communicated to you by your bank before the change occurs.
What is the disadvantage of P and I loans?
As monthly repayments for P and I loans are higher than repayments for IO loans it’s important to ensure you budget appropriately.
How do IO loans work?
When you take out an interest only loan, your monthly repayments only cover the interest charged by the lender for that month and there is no reduction in the balance of the loan.
IO loans must be paid off in the same timeframe as P and I loans. This means the IO component of the loan is usually only valid for a maximum of five years before it must be renewed or converted to P and I.
What is the advantage of IO loans?
Not having to repay the principal each month means your monthly loan repayments are lower compared to a P and I loan.
What is the disadvantage of IO loans?
IO loans will cost you more in the long run than P and I loans for two reasons:
- As the loan balance won’t be reducing during the interest only period, the interest charged will be calculated on the full balance every month.
- Banks will also normally apply a higher interest rate to their interest only loans compared to principal and interest.
At the end of the IO component of your loan your monthly repayments will increase to cover the principal and interest charged. These repayments are usually higher than a standard P and I loan as there is less time remaining to pay off the loan.
For example, if your 30-year loan has a five-year IO period you will only have 25 years to pay off the principal as you have only been paying off interest in the first five years.
As you are not paying off the principal, IO loans don’t build equity. This could be an issue if your circumstances change and you want to sell your property, particularly if there has been a downturn in the market and the property is worth less than it was when you took out the loan and you may find yourself in ‘negative equity’.
When would an IO loan be beneficial?
The most common reasons for taking out an IO loan are to maximise tax deductions on an investment property or for bridging finance and construction loans.
Bridging finance is a type of temporary loan that can be used when you want to sell a home that you own in order to buy a new one. It allows you to buy your new home and then pay out the bridging loan when you sell your old home.
Construction loans are designed to minimise the interest you pay on a loan while building a home. You do this by only drawing down when each stage of the house construction is completed. Once the house is finished, the loan can be converted to a P and I loan.
The information in this article has been prepared for general information purposes only and not as specific advice to any particular person. Any advice contained in the document is general advice and does not take into account any person’s particular investment objectives, financial situation or needs. Before acting on anything based on this advice you should consider its appropriateness to you, having regard to your objectives, financial situations and needs.