Should You Choose an Interest-Only or Principal-and-Interest Loan?

Buyers, Sellers,  Buyers and sellers

What’s the difference between interest-only and principal-and-interest loans? We’re breaking it down to better equip real estate agents to guide potential buyers through the purchase journey.

What is Interest-Only?

Interest-only means monthly repayments will only cover the interest owed on the home loan. The principal sum will remain untouched. The obvious upside here is those monthly repayments will be more modest, generally by around 15%. The downside is the principal will keep accruing interest, leaving you with a more expensive overall repayment. Keep in mind, most interest-only loans will revert to principal-and-interest after a period of five years, though sometimes up to 10 years. Afterwards, monthly repayments will be higher than they’d have been if both principal and interest were paid from day one.

For a comprehensive look at the cost differences, check out this detailed breakdown by the Australian Securities and Investment Commission. Since interest-only loans typically have higher interest rates, shopping around is even more crucial than usual. Additionally, whether the home loan is for an investment property or an owner-occupied home will help determine which option is the most beneficial.

Why Consider an Interest-Only Loan for Your Investment Property?

If the loan is for an investment home, interest-only means rent will cover most, if not all, of your monthly mortgage repayments. This makes it much easier to save for renovations, further investments or a rainy day. Cheaper payments might only last five years, but a half-decade’s savings are nothing to scoff at.

Five years of smaller payments also comes in handy if the budget for the investment property is tight. However, you’d need good reason to believe you’ll be in a stronger financial position down the track. This is especially useful for starting the investment as soon as possible to capitalise on predicted price growth.

Interest-only loans are useful for tax purposes, too. Interest accrued on a loan for an investment property is tax deductible, but payments made against the principal sum aren’t. This means if you’re only paying interest, you can claim the entire payment on your personal tax return.

On the flipside, having an easier first five years is followed up with a more difficult term remainder. All the while you’ve been paying off interest, the principal sum has been accruing yet more interest. Therefore, come the end of the loan, you’ll have paid a greater total sum.

Another problem arises if you decide to sell the property early. Not having paid off any of the principal sum could mean ending the transaction at a net loss. The only way to avoid that loss is if the property’s capital growth is larger than the cost of selling the home. The likelihood of that varies dramatically from property to property.

 

Which Loan is Better For Owner-occupied Properties?

If the home loan is for an owner-occupied property, the story is a little different. The basic principles still apply, but there are some added considerations.

For example, a principal-and-interest loan brings the option of redrawing from the principal sum. While this is useful for covering emergency costs, it’s a bad idea to get into the habit of doing so. In addition to paying the sum back, the renewed principal will result in more interest. Still, it’s an option interest-only payment plans can’t offer.

Paying off the principal from day one also means immediately building equity. If, for any reason, the home needs to be sold before the mortgage is paid off, the chance of making a profit is greater because of how much less is owed to the bank.

The most tangible bonus of all, however, is simply paying less interest over the lifetime of the loan. Meanwhile, the only significant drawback is having higher monthly payments in the early stages of the term. Even that is offset by the fact your repayments will be cheaper beyond the first five or so years.

Unfortunately, the only real benefit in taking out an interest-only loan on an owner-occupied home is cheaper early repayments. Even the tax benefits don’t apply to an owner-occupied home like they do for an investment property. It’s vital to always assess your options independently, however. Do your research and gain a solid understanding before deciding between interest-only and principal-and-interest loans.

 

Important disclaimer: This article is provided for general information only, and the author is not engaged to render professional financial advice or services through this article. Readers should satisfy themselves as to the correctness, relevance, and applicability of any of the above content, and should not act on any of it in respect of any specific purchase, investment, or other financial activity without first obtaining their own independent professional financial advice.

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