Home loan repayments: principal and interest vs. interest-only

When paying off your home loan, you’ll be able to choose between two mortgage repayment options: principal and interest (P&I), or interest-only (IO). 

Which one you go with will depend on your reasons for buying the property in the first place, along with your financial circumstances.

So let's break down what these home loan terms mean, and how they're useful for owner-occupiers and property investors. 

The principal and the interest are the two main parts of your home loan repayments.

• Your principal is the initial loan amount you borrowed to buy the property.
• Your interest is the lending rate charged on your outstanding principal (calculated daily).

As the name suggests, principal & interest home loans require borrowers to pay off their principal balance in chunks and the interest it accrues at the same time. 

Principal & interest repayments are more expensive than interest-only repayments. However, by paying off the principal loan balance, you're growing home equity in the property and lowering the amount of interest you'll pay in the long run. 

When you take out a home loan, your lender will calculate the minimum principal and interest repayments you’ll be required to over the life of the loan. Each lender does this slightly differently.

In general, your lender calculates your minimum mortgage payments by "amortising" (dividing) your principal over your chosen loan term (typically no more than 30 years) at the intervals you request (fortnightly vs. monthly), then adding interest.

Interest is usually calculated daily by multiplying the interest rate against your remaining principal balance. Monthly mortgage repayments typically include 30-31 days of interest.

This is why making extra repayments can save you interest: your interest rate is calculated against a smaller principal each time.

Making principal and interest repayments comes with a few important pros.

• Lower interest rates. Paying both the principal and interest on a home loan makes you less of a risk in banks’ eyes since you're increasing the level of security in the mortgage, so you’ll be offered cheaper rates than you would be on equivalent interest-only home loans.
• Pay less interest overall. Since your scheduled repayments chip away at both the principal loan amount and the interest owed, you’ll wind up paying less interest over the life of the loan than you would with an interest-only loan.
• Grow home equity. Because you're making repayments against the actual value of your property, you grow the value of your ownership. This value is called home equity. Your home equity can be used to do many things, like refinance, buy an investment property, or renovate.

On an interest-only loan, borrowers will pay down just the interest portion along with any associated lender fees for a fixed amount of time (usually no more than five years).

Since your repayments won’t go towards paying off the principal, your outstanding loan balance will remain the same unless you choose to make extra repayments. 

Once the interest-only period expires, you’ll have to start making principal and interest repayments, which can be significantly higher depending on how many years remain on your loan. 

While interest-only loans tend to be associated with property investors (particularly those who want to renovate the property and sell again, see capital gains tax for investors), they can also be useful for other types of borrowers, too.

Here are just a few ways that you can benefit from making interest-only repayments – and some traps to look out for. 

Advantages of interest-only repayments

• Smaller repayments. If your budget suddenly tightens or you lose an income stream, switching to interest-only repayments for a period of time can provide significant, albeit temporarily, financial relief.
• Tax incentives. If you’re a property investor, interest-only loans can help maximise cash flow and free up money for further investment, such as a second property or a "flipped" property. You’ll also be able to claim tax deductions against the interest paid on your loan.

Disadvantages of interest-only repayments

• The principal stays the same. While your mortgage repayments will be lower for the time being, the principal amount will continue to collect interest, which means you’ll pay more over the life of the loan. 
• You’ll have to make up the repayments. Once the interest-only period ends, your lender will adjust the terms of your loan to make sure you’re still able to pay it off in time. The sudden jump in mortgage repayment size might come as a shock if you’re not prepared.
  

Different home loans types have different interest rates. This is because lenders view home loans by borrower type. Riskier borrowers often pay higher interest rates.

Fun fact, this is why home loans with loan-to-value ratios (LVRs) at 80% or under tend to have cheaper interest rates: the borrower has more security built into their mortgage. 

Let's look at the current averages in the Mozo database for different kinds of home loan borrowers, including what types of repayments they're making.

• Average owner-occupier principal & interest rate: 6.84% p.a.
• Average owner-occupier interest-only rate: 7.45% p.a.
• Average investor P&I rate: 7.18% p.a.
• Average investor IO rate: 7.45% p.a.

Rates current as of 20 December 2023.

Confused? Here is why investors pay higher interest rates. 

Use our mortgage repayments calculator to determine how much you would pay under home loans of different types. 

Browse great value home loans using our home loan comparison page.