Repaying your mortgage generally means paying down a portion of your principal balance as well as some of the interest that has accrued through the cost of borrowing.
In the context of home loans, the principal is the amount you borrow and interest is what the lender charges you as the cost of borrowing.
Principal & interest repayments are the most common way that borrowers choose to pay down their mortgage, allowing them to pay down their debt and build equity in their home.
However, lenders may also offer interest-only payments for a length of time, meaning that the borrower only repays the interest portion of the loan during this period.
Since the 2017 Banking Royal Commission, lenders now charge a premium for interest-only payments to incentivise borrowers to focus on paying off their debt. As a result, interest-only repayments will usually incur interest rates 0.5-1% higher than principal and interest repayments.
Differing rates and the way you repay your mortgage will have big consequences over the course of your home loan, potentially making tens of thousands of dollars worth of difference.
In this article, we’ll break down the difference between both repayment types and give our verdict on how you should be repaying your home loan.
What are the key differences between principal and interest and interest-only payments?
Principal and interest
- Each payment reduces your principal plus a portion of the interest
- You build equity in your home sooner and pay down the principal faster
- You generally pay a lower interest rate than for interest-only
- You’ll ultimately pay less interest over the course of your loan
- Principal and interest repayments are larger than interest-only payments during the interest-only period
- Payments only cover the interest portion of the loan
- Payments are smaller during the interest-only period
- Once the interest-only period finishes, repayments become significantly large
- You pay a premium for interest-only payments, meaning higher interest rates on your mortgage
- You’ll end up paying more interest over the course of the loan
- You don’t build equity in your home during the interest-only period
How to decide if interest-only repayments are right for you
The way you structure your mortgage repayments will ultimately depend on your own financial and property situation.
When taking out a home loan, your intentions for the property are an important consideration when choosing your repayment type. Follow the criteria below to help you decide whether interest-only will be more beneficial for the repayment of your home loan.
Interest-only may not be right for you if:
- You’re an owner-occupier. Unlike property investors, owner-occupiers can’t claim the same tax deductions on their interest payments, which largely diminishes the benefit of choosing interest-only. For this reason, we almost always recommend to owner-occupiers that they focus on repaying their debt and building equity in their home.
- You’re a first home buyer or new to holding a mortgage. When it’s early on in your loan journey and you’re less experienced with budgeting and repayments, paying down the principal of the loan is often the safest and best path to becoming debt free. Getting used to paying back debt is healthy and will encourage you to manage your money effectively from the beginning.
- You have a high loan-to-value ratio. A high LVR means you don’t have much equity to absorb the financial risk if things go wrong. If you lose your job or need to sell your home, the principal you’ve paid down in your home will protect you from not being able to pay down the outstanding value of the loan. This is why, if you’ve taken on a large amount of debt, we always promote building up equity first and foremost.
- You don’t have a defined wealth plan. One of the main reasons for borrowers choosing interest-only repayments is the smaller mortgage payments during this period. Unless you have strong investment knowledge and a clear wealth strategy, your money is likely better spent working to pay down the principal of your loan.
Interest-only may be right for you if:
- You’re a property investor. Given that interest charges on investment loans are tax-deductible, opting for interest-only on an investment property will help you maximise deductions from your tax bill. These savings can in turn be used to pay down the mortgage on your own home or other investment properties.
- You’re great at budgeting and can accept the premium. With repayments smaller during the interest-only period, the money not spent needs to be put to good use for the endeavour to be worthwhile. If you’re the type of person who is likely to spend whatever money is in your bank account, the premium rate combined with higher payment sizes after the interest-only period will likely leave you worse off in the long run.
- If you have built up equity already. Equity is your fallback during times of crisis and is what you have to show after years of paying off loans. If you have substantial equity built up in other properties or assets, then the risk of financial hardship is significantly reduced.
- You’re comfortable with debt. Most of us want to be debt-free by the time we retire, so this goal should be planned for accordingly. Younger mortgage holders may be more comfortable having significant liabilities whilst older borrowers may prefer to be paying down the principal as fast as they can.
So what’s our verdict?
Of course, every situation is different and our advice always starts with your goals and how can your adviser structure the right solution for you. However, if you have asked for our preference, then we would always advocate for principal and interest.
Principal and interest is a constant reminder that you have to repay your debt and to keep being prudent with your savings and personal budget.
As life gets busier and time goes faster, principal and interest is the gift that keeps on giving. If your plan for retirement is to have no debt and have income from investments, then focusing on paying off debt is the quickest way to get you there.
If you want to see what both principal and interest and interest-only repayments will do over the course of your home loan, you can check out our mortgage repayment calculator here.
Before making a decision on your home loan repayments, make sure you’re well informed and seek professional advice when necessary. You can also use our mortgage repayments calculator to see how different repayment structures will affect your mortgage.