Principal and interest vs interest only repayments: which is better?

There are different ways to repay your home loan. No, you can’t reimburse your lender with macaroni jewellery made by your kids, but you can choose to make repayments of either principal and interest, or just interest. 

Principal and interest repayments mean that you pay off both the principal (the amount you’ve borrowed) and the interest charged by your lender. This option usually results in higher repayments, but will also reduce your loan balance more quickly.

Interest only repayments, on the other hand, mean that you only pay the interest charged on the amount you’ve borrowed. This option is usually cheaper in the short-term, but over time you will end up paying more in interest. Plus, the money that you’ve actually borrowed is still owing. 

To work out which repayment option is best for you, it's important to consider your financial situation and goals. Our repayment calculator can help you compare the two options and work out what you can afford each month.

Check out our financial calculator and work out which repayment type is best for you. 

What are the different loan repayment types?

When you apply for a loan, you may be able to choose whether you want to pay down the principal amount, together with any interest accrued, or just make the interest payments for an agreed period. This interest only period can be anywhere from one to five years and is subject to approval. 

Principal and interest repayments:

• You agree to repay the principal amount of the loan — the amount you borrowed to buy your property — as well as any interest charged on that amount. 

• You will generally pay a lower interest rate than the amount charged for an interest only loan. 

• Your monthly repayments are higher, but you pay off your loan faster and with less interest over time. 

• This may not be tax efficient for investment loans, so speak to your accountant about it. 

Interest only payments:

• You only pay the interest charged on the amount borrowed for a fixed period — usually between one and five years. 

• Your interest rate will likely be higher than a principal and interest loan. 

• When the interest only period ends, your current interest rate will still apply. 

• This is a good way of minimising repayments for a period to suit your financial situation, however you will end up paying more interest over the life of the loan.

How do principal and interest repayments work? How does it affect how much I pay on my mortgage?

Say Jason and Kate both borrowed $600,000 on a 30 year loan term, with a two year variable interest rate and a loan to value ratio of over 70%. 

Jason chooses to repay principal and interest from day one, whereas Kate makes interest only payments for the first three years. 

Jason’s interest rate is 4.49% p.a., whereas Kate pays 5.05% p.a.*  Each month, Jason’s mortgage repayments are $3,047 per month. Kate pays $2,525 per month. 

Repaying the principal amount, as well as interest accrued, will obviously help you pay off the total amount of your loan faster. And, depending on what Australia’s exceptionally volatile credit rate does over the next decade, this likely also means you’ll pay less interest on a smaller amount over time. 

Pros of principal and interest home loan repayments:

By paying off your principal and interest amounts, you’re paying off your mortgage sooner, reducing the amount of interest you pay over the life of the loan, and getting to a place where you own your property outright faster. 

Demonstrating your willingness to pay down your loan also gives you more leverage to negotiate lower interest rates — a HUGE advantage in this brutal lending climate — and you’ll find it easier to refinance down the track. 

Cons of principal and interest home loan repayments:

If you choose to make principal and interest repayments from the outset, your monthly repayments will be higher because you’re paying both principal (the amount you’ve borrowed) and interest. This can make living life — buying furniture for your new home or generally doing the things you love — a bit harder on a tighter budget. 

What’s more, if you’ve purchased your property as an investment, making principal and interest repayments isn’t always the most tax effective option, meaning you don’t enjoy the full tax benefits of your investment property portfolio. 

Pros of interest only repayments:

Interest only loans and lower repayments can be a great option if you need some extra cash in the short term. Perhaps you’re taking some time off work for family commitments, investing in a business or you’re looking to pay down other loans before starting on the principal amount of your home loan. 

Interest only loans are also great for property investors looking to claim higher tax deductions while also benefiting from capital growth. Interest can sometimes be offset against rental income or other eligible property costs, and investors may also be able to claim a tax break for up to 12 months of prepaid interest. 

Cons of interest only repayments:

As the name suggests, interest only repayments means that you’re only paying the interest charged on your loan, which means the amount you borrowed is still outstanding. This means that you’re paying more interest over the life of the loan AND at a higher rate (the higher rate you were paying during your interest only period still applies once you begin paying off the principal amount). It also means you have more debt on your balance sheet, and for a longer period.

Interest only loans are also harder to get because you have to prove you can repay your loan amount over a shorter time frame. So, in the example above, Kate has to qualify for her $600,000 home loan at 5.05%, over 27 years rather than 30 years. Remember: her interest only loan does not repay any of her principal borrowings for the first three years. It only pays the interest.

This also means Kate's principal and interest repayments (starting in year 4 of her loan term), will be a lot higher than Jason's, as she'll still owe $600,000 at this point, and Jason will owe less.

Can I switch from interest only to principal and interest repayments?

Lenders genuinely understand that the lifestyle and financial situation of their customers can change very quickly, and most financial institutions are open to discussing changes to your repayment type. 

Talk to your lender or financial advisor about:

• Switching from principal and interest to interest only

• Switching from interest only to principal and interest before the end of your agreed period 

• Extending your interest only period

Compare products or use our financial calculator to determine whether your current loan is the best you can get.  

Which loan is right for me?

Choosing between a principal and interest loan, and an interest only loan really comes down to your financial situation, whether you’re looking to pay down your loan as fast as possible, and whether you might benefit from potential tax deductions in the long run. 

If you're looking to reduce your loan as quickly as possible, then making principal and interest repayments is the way to go. However, if you're wanting to keep your repayments low, then interest only could be the right option for you.

One way to assess your repayment options is to use our handy calculator. This shows you the difference between principal and interest repayments, and interest only repayments, both in terms of money and time.

If you're currently making interest only repayments on your loan and want to switch to principal and interest, our home loan experts can help you make this transition. Get in touch today to find out more.

Get started with our FREE repayment calculator:

*Based on Commbank interest rates September, 2022