Firstly what is the difference between the two?
Principle and Interest Repayments
Principle and Interest repayments mean that your monthly repayment is made up of 2 components, the interest, and the principle. Or P&I. The interest is the part that goes to the lender at the agreed interest rate, and the principle is the part that goes towards paying down your loan amount. At the start of your loan, your interest makes up the majority of the repayment with a small amount making up the principle. It may feel like your loan is barely even moving at all when you first start making repayments. Over time, as your loan progresses, the interest payment gets smaller and the principle payment increases, even though your loan repayment stays the same each month. Towards the end of your loan, the principle takes up the majority of the payment, with very little interest making up a part of the payment.
See the graph below showing the first 12 months of a $450,000 loan.
See how the first repayment is made up mostly of interest?
Now let’s take a look at the final payments of a 30-year loan. In this graph, most of the payment is made up of principle, with a very small interest component. The majority of your loan is paid off in the final years. This is so the lender re-coups as much interest at the start of the loan as possible. This is called Loan Amortisation, but more about that later.
Generally, you would set your Owner Occupied Property (where you live), to Principle and Interest repayments. This is so you build up equity in your home from the start and it safeguards you against property prices taking a downturn. You can later use the equity in your home to purchase your next home or investment property. It is wise to put extra money into your home loan if you can from the start, as any extra repayments will go towards reducing the principle faster and building up that equity quicker.
Interest-only repayments, quite simply, means that you only pay the interest and make no payments off the principle. Most lenders will limit the amount of time you are able to do this and usually only offer this option to Investment lending. The interest-only period is usually 5 years and when it finishes, your loan rolls onto principle and interest repayments.
As an investor, you have the option to reset your interest-only period for 5-10 years at a time when your interest only period comes to an end.
During the 5 year period of interest only, your loan will not reduce at all.
See the graph below: Notice how the Balance remains the same over the course of 1 year?
Disadvantages to IO loans:
It is important to note that once your loan rolls back to principle and interest after the 5-year interest-only term is up, your repayments will be more than they would have been if you had not taken the 5 yr IO term. This is because you now only have 25 years to repay the loan instead of 30 years. Your principle repayment will need to increase to allow for the 5 years you were not putting a dent in the loan amount.
Investors may consider resetting your entire loan term back to 30 years as part of a refinance, to maximize your serviceability and allow you to continue with interest-only repayments for a longer period.
Also, it is important to be aware of the difference in interest rates. Interest-only rates are often higher than the Principle and Interest rates.
Advantages to IO loans:
So why would anyone want IO repayments? Well, there are a couple of reasons, particularly aimed at investors.
Your overall monthly repayments are lower as you are not making the principle payment. Keeping your monthly repayments down increases your borrowing capacity for additional property purchases or other investments. While investors are in the accumulation phase of purchasing property, interest-only repayments allow them to borrow more money and purchase more property, than they would otherwise be able to if their repayments were Principle and interest.
Your balance does not reduce. Although this sounds like a negative, it can in fact be positive to an investor. Investment debt is tax-deductible debt. The more investment debt you have, the more of a tax deduction it is. Keeping your investment debt high, keeps your tax deductions at a maximum.
Setting your investment lending to Interest only, allows you to put more funds towards your owner-occupied property and pay that down first. Owner-occupied lending is not tax-deductible, therefore you want to get rid of that debt as soon as possible.
Speaking to a mortgage broker can help you decide which is the best repayment type for your circumstances. There are so many variables to consider and making the wrong decision can hinder your chances of borrowing down the track.
If you would like more information, please book in a time to speak with a Mortgage specialist