Interest Only vs Principal and Interest Loans
11 min read
Last year, there were a lot of changes to interest only lending in Australia. Basically, the bank regulator APRA put their foot down on banks in Australia and what they deemed “risky lending practices”. The result has been Aussie banks increasing their rates on interest only home loans to make them less affordable with interest only loans dropping to just 16.9% of loans settled in the last quarter of 2017.
The concern we’re starting to hear now is what happens when a lot of these interest only loans come to the end of the interest on period with some commentary in the media that a lot of Aussies won’t be able to afford their repayments if they are required to pay principal and interest.
What’s the big deal with interest only?
The way APRA saw it, household debt was too high (in relation to income levels) and was contributing to the rising house prices in major property markets like Sydney and Melbourne. Interest only loans make it cheaper initially for people to take out loans, potentially contributing to bigger loans upfront. The RBA are also concerned with our ability to repay loans, when the interest only period ends and that it may result in ‘financial stress‘ if household circumstances change.
Whilst we don’t necessarily agree that interest only lending has had such an impact to house prices and lending, it can’t be denied that there has definitely been a slow-down in the housing market over the last few months.
In all cases, when you apply for a loan, the lender assesses your ability to repay the loan based on principal and interest repayments (usually based on a term of either 25 or 30 years) so it’s not entirely true to say that you could borrow more by taking out an interest only loan.
Let’s take a fresh look at what the two different loan options are and what circumstances you might take out interest only compared to principal and interest loans.
There are a few different ways you can structure your home loan, and one of these relates to your repayments. You can choose whether you would like to make repayments on your loan that include paying down the principal of the loan (i.e. the money you owe your lender) or whether you would like to pay only the interest charges each month.
As the name suggest, an interest only structure on your home loan means when you make your repayments each month you are only paying the interest charged. This means you aren’t paying down any of the money you owe (the principal) during this period. Interest only loans generally only last for 5 years, after which time they will revert to Principal and Interest.
Over recent months the Australian government have made legislative changes to encourage people to pay off their debts. This means many banks are charging higher interest rates on interest only loans, this is for both owner occupied and investment loans.
Why would someone choose interest only?
If your budget is tight, you might choose to opt for the interest only as the minimum repayments are lower. You can still choose to pay extra each month on top of the interest only amount payable, but the minimum required to pay is generally lower.
Many investors will choose interest on loans so they have increased cash-flow. This allows them to purchase additional investment properties and chase capital growth as a means of growing their wealth, as opposed to paying down the principal.
What do you need to be aware of if you choose interest only?
- You may end up paying quite a bit more interest over the life of the loan if you choose not to pay down any of the principal within the first ten years – this is because interest is charged based on the amount you owe. If you are paying down the principal then the overall interest payable will reduce each year compared with if you are paying interest only, the repayments will not be going down any time soon.
- Unless you are planning to sell the property to pay off the loan, at some point the principal of the loan is going to need to be paid off. Interest only loans apply for a fixed term, usually no more than 5 years, after which time you’ll be required to start paying down the principal. You’ll find you have less time to do this though, so your repayments will be bigger.
- Appreciation on the property is a good thing, depreciation is not (in most circumstances). If your property loses value while your loan is set to interest only, then you may end up owing more than your home is worth. The end result being if you sell your home, you may still owe the bank money once the sale has gone through.
Principal and Interest
A principal and interest loan is structured so that you are paying both the interest and the principal on the home loan from the beginning. This means you will be reducing how much you owe the bank each month, and the interest charged is going to decrease from the beginning (depending on how often it is calculated).
In each repayment, some of the money is allocated to repaying the principal and some of it is allocated to repaying the interest owed. At the start of the loan only a small part of the principal is repaid however as the loan goes on a larger amount of your repayment is allocated to repaying the principal.
Why would someone choose principal and interest over interest only?
If you want to pay down your loan and be mortgage free, then principal and interest may be the way to go. The bank will calculate what your repayment is over the life of the loan (this might be 25 or 30 years) and each month/fortnight/week you’ll pay this back.
If you want to pay your loan off faster, then additional repayments on top of your minimum loan repayment will reduce your debt (by as much as a few years depending on how much you contribute).
If you decide to sell your home, then you’ll probably have less to repay the bank too, which means you might walk away with a capital gain to put towards your next property.
What do you need to be aware of when choosing principal and interest?
- Minimum repayments will be higher than if you opted for an interest only loan as you are paying off the principal from day one.
- If you have an investment property then you may not be planning on paying off the principal owing for tax or other investment purposes. A principal and interest loan may not be the best structure for this strategy.
When it comes to selecting your home loan, it pays to get some advice. The team at Entourage are happy to review your circumstances and help you formulate a strategy to make the most of your loan.