Home loans explained
Is a principal and interest loan best for you?
2 min read
One of the things you’ll need to consider when looking at home loans, is whether you want a principal and interest, or an interest only loan.
As the name suggests, principal and interest (P&I) loans mean you are paying both the principal and interest on your home loan.
Your home loan is made up of two parts:
The initial amount you borrowed to buy your property.
What your lender charges for borrowing money.
There are two methods of repayment when paying off your home loan: interest only and principal and interest. Interest only repayments are when you only pay the interest charged each month and do not pay off any of the principal amount. This sort of repayment is usually only available for a fixed period of time. Principal and interest repayments mean you are paying off the principal as well as the interest that is charged.
Home loan interest is calculated on your principal loan amount. So, the more you pay off of your principal loan amount, the less interest you will have to pay over time. Interest only payments mean you are only paying the interest your home loan generates, and not reducing your principal loan amount at all. This means your interest is calculated on your full loan amount for the whole of your interest-only period, as well as when you first start making P&I payments. Principal and interest payments reduce your principal amount right from the start, which means overall, you’ll end up paying considerably less interest over the life of the loan.
Making principal and interest payments will also increase the equity in your home. Equity is the term used for the difference between your property’s value and how much you owe on it. So say you had a house worth $500,000 and you had $400,000 left to pay on your home loan, you would have $100,000 in equity. Equity can be used for lots of different things, such as a car, funding renovations, or as a deposit for your next home.
There are certain tax benefits that can come with interest-only repayments. As an investor you can claim the interest you pay on your investment home loan as a tax deduction. So, while an interest-only repayment would be completely tax deductible, only the interest portion of your P&I repayment would be.
Unfortunately, if you’re paying off your principal and interest, your repayment amount will be more than if you were making interest-only payments. You won’t have as much free cash on hand because you’ll be paying to cover the cost of interest as well as paying off your principal loan amount. But by doing this you won’t be paying as much interest over the life of your loan.