Home loans: Is interest only or principal and interest right for me?

When applying for a home loan, it's important to consider all your options and ensure the loan is the right one for you and your family. And as your circumstances and lifestyle change, your loan requirements may change as well.

The type of repayments you make is one of those important considerations - are interest-only or principal and interest payments right for you?

If you're an owner-occupier, principal and interest payments are the most common way to make repayments, but for some (especially property investors), making interest-only payments can have a number of benefits. Let's take a closer look.

The difference between interest only & principal and interest home loans

The majority of home loans in Australia are principal and interest home loans. That means that each home loan payment includes a contribution toward:

1. Principal: The original loan amount. These principal repayments reduce the loan amount until it's fully repaid or settled.
2. Interest: The charge your lender applies for borrowing money from them.

Your other option is to make interest-only payments. As you'd expect, this type of payment only pays the interest charges of your loan, it does not reduce your loan's principal amount.

With an interest-only home loan, you'll pay only interest for a set term - usually between one and five years. After that interest only term runs out, your repayments will revert to principal and interest. In most cases this means your repayments will increase.

Structuring your home loan this way may have several benefits, but it's not without risks and drawbacks.

Interest only and principal and interest pros and cons

Repayments

Interest only home loans have lower repayments than principal and interest home loans during the interest-only period (because you are only paying interest, not principal).

However, when the interest only period ends and your loan reverts to principal and interest, your repayments will increase.

In fact, they will exceed what they would have been if you'd been making principal and interest repayments for your entire loan term. This is because you won't have paid off any of your principal balance during the interest only period. Therefore, the balance outstanding on the loan at the end of the interest only period will not have reduced from the start of the loan, compared to if you had been paying off principal the whole time.

Total cost

Interest-only home loans may be more affordable in the short-term, but they will likely cost you more across the total duration of your loan.

That's because, as discussed above, your loan principal remains unchanged for the entire interest-only period. Your interest amount won't start reducing until you start paying off principal and therefore the balance outstanding on your loan reduces, which in turn reduces how much interest you pay. To give you a clear picture of the potential cost difference, let's take a look at an example**:

     *Interest only *Principal and interest   Loan amount $500,000 $500,000   Interest only period 3 years N/A   Monthly repayments during interest only period $1,038 N/A   Monthly repayments during principal and interest period $2,121 $1,973   Total interest payable $224,617 $210,282    

* Assuming an interest rate of 2.49 and a loan term of 30 years.

As you can see, the monthly repayments are much lower during the interest-only period, then slightly higher (compared to a loan without an interest only period) for the remainder of the loan term. More importantly, the total interest paid is over $14,335 higher for the loan with the interest-only period.

The risks of interest-only home loans

Interest-only home loans can help you manage your costs initially, however there are risks you may encounter if you're not careful when borrowing and planning for the future. A few common risks and pitfalls include:

• You may find it difficult to afford repayments when they increase after the interest only period ends.
• If house prices do not increase during your interest-only period, you won't build up any equity (in addition to your deposit amount). Even worse, if house prices fall, you may end up with negative equity - meaning your home loan is worth more than your home.
• You may be charged a higher interest rate during the interest only period.
• Interest rates vary and while rates are currently low, they may go up, meaning when you transition to principal and interest payments, you may be paying a higher interest rate, as well as a contribution towards the principal.

If you're considering an interest-only home loan make sure you keep the above risks in mind and take steps to manage them.

Which loan type is right for you?

Since 2017, over 80% of new home loan lending in Australia has been to borrowers making principal and interest repayments, according to CoreLogic data¹. That's because, in most cases, it's better to make principal and interest repayments and reduce your loan amount each month, with the goal of eventually being mortgage-free.

With that said, here are a few examples of when an interest-only loan may be a smart option:

• Property investment: investors may be able to claim higher tax deductions with an interest-only loan as well as enjoying improved cash flow.
• Short-term loans: When borrowers need to temporarily minimise costs with loans such as bridging finance and construction loans.
• Hardship or illness: if you're experiencing financial hardship or illness, a temporary reduction of mortgage repayments may help you get through.

When applying for a home loan, it's essential that you take a close look at your circumstances, your lifestyle and your budget and design a mortgage that suits you. To get started and find out what type of loan is right for your circumstances, contact Qudos Bank's home loan specialists today.

¹ Housing lending may be cheap, but regulators argue it is not yet risky (corelogic.com.au)