Principal and Interest vs Interest Only Home Loans

When taking out a home or investment property loan in Australia, borrowers may be offered or may consider two common repayment structures: principal and interest, or interest only. Understanding how each works can help borrowers ask better questions of their lender and obtain appropriate advice for their circumstances.

A principal and interest (P&I) loan generally involves regular repayments covering both the interest charged and part of the outstanding principal balance. If the interest rate and loan conditions remain unchanged, the interest component generally reduces as the loan balance falls.

A larger proportion of each repayment commonly goes to interest in the earlier years of the loan. The proportion going to principal typically increases over time as the balance falls. The loan is intended to be repaid by the end of the agreed term, provided repayments are made as required and loan conditions are met.

An interest-only (IO) loan generally involves scheduled repayments that cover interest during the interest-only period. Principal generally does not reduce unless extra principal payments are made above the scheduled amount.

Interest-only periods are usually limited. The loan may move to principal and interest repayments under the lender's terms or an approved variation when the interest-only period ends. Interest rates, fees, eligibility and available interest-only terms vary by lender and loan product and are subject to lender approval and conditions.

Under a principal and interest structure, the loan balance generally reduces over time with each scheduled repayment. The proportion of each repayment going to principal may increase as the balance falls, assuming the interest rate, repayment schedule and loan conditions remain unchanged.

Under an interest-only structure, the loan balance generally remains unchanged through scheduled repayments during the interest-only period. Most or all of the principal may still be outstanding at the end of the interest-only period if no extra principal repayments are made.

When the interest-only period ends, the loan will generally move to principal and interest repayments under the lender's terms unless another arrangement or approved variation applies. Repayments may be substantially higher because the principal may not have reduced during the interest-only period and the remaining repayment term is shorter.

For example, a 30-year loan with a five-year interest-only period may require the remaining principal to be repaid over the remaining 25 years, which can result in a meaningful increase in the required repayment amount. The actual repayment change will depend on the outstanding balance, interest rate, remaining term, applicable fees and the lender's calculation method. Confirm the expected repayment change with your lender before committing to an interest-only structure.

The factors relevant to a borrower's choice of repayment structure may differ depending on the loan purpose and individual circumstances. Investors may consider cash flow, investment objectives, equity, lender requirements and potential tax treatment. Owner-occupiers may focus more on reducing debt, building equity through principal repayments and limiting total interest paid over the loan term.

Neither structure is automatically more suitable for a particular borrower type. Obtain qualified advice that takes into account your specific loan purpose, financial circumstances and objectives.

Lenders assess a borrower's capacity to meet repayment obligations when approving loan applications. That assessment may differ between principal and interest and interest-only structures. Lenders may consider the expected repayment level after any interest-only period as well as assessment rates, income, expenses, existing debts and other criteria in accordance with their policies and applicable regulatory requirements.

Interest rates, fees, maximum interest-only periods and eligibility requirements vary by lender and loan product. Confirm the applicable requirements and any differences between structures with your lender or a licensed mortgage broker.

Taxation treatment may be relevant where a loan is used for investment property purposes. Outcomes depend on the purpose and use of the borrowed funds, the borrower's circumstances, applicable taxation law and any later changes to the loan or its use.

This guide does not determine whether interest or other borrowing costs are deductible or otherwise relevant for taxation purposes. Obtain advice from a registered tax agent or an appropriately qualified taxation professional before making decisions based on anticipated tax outcomes.