The difference between Principal and Interest repayments and Interest only repayments
Confused about how to repay your loan? Don’t worry we have got you covered. Buying a house can be one of your most important life decisions.
Financing your home loan can be a tedious task but organizing your repayments strategically would provide some benefit in the long term. There are two ways to repay your loan:
- Paying the principal amount and its interest on the home loan (P&I)
- Paying interest for initial years of your home-loan period only (IO)
What is a Principal and interest repayment (P&I)?
- They are formulated to be paid over the term of the loan – usually 30 years.
- It is calculated by taking in account a portion of the principal amount, loan fees and interest charged over the defined loan term.
- You pay off a bigger part of your principal since the interest component and loan balance lessens as the time goes by.
- Rates on principal and interest repayments might be lower compared to interest-only payments.
What is an Interest-only repayment (IO)?
- With Interest-only repayments, you are required to pay only the interest charges and fees (if any) for the period decided by the lender.
- You can request the lender to negotiate a new interest-only contract after the original expires (usually expires within 1-10 years).
- As they are of a limited period, it is better not to consider them only for lower repayments. After the IO period, you may pay more over the remainder of the loan period as you’ll have to include the principal amount in your repayments.
Is P&I repayments best suited for your needs?
It generally requires the borrower to pay off principal repayment and interest amount of the home loan. It is the best option for people who want to own their property entirely as you’re paying off the borrower amount along with the interests even though this may look like you’re paying a larger amount than IO but in fact, you’re increasing your share in the property and taking the edge off the interest payments you’ll have to make in the future.
For better understanding, let’s assume that you need to borrow a $500,000 home loan for 25 years at an interest rate of 4 %. Which means you’ll be paying $2649 per month with a total interest of $294,755 for 25 years.
Or is IO repayments a better option?
People who invest in properties, generally prefer this option if they believe that property prices are going to increase in the future. If investors are planning to borrow a loan to buy residential investment property earning rental income, the interest that they’ll pay can be claimed for a tax deduction.
They can also practice negative gearing; borrowing money to own an income-generating property, where the money received from this property will be more than the ownership and maintenance cost of the investment.
Borrowers can take advantage of the cash flow benefits by using the principal amount freely for other purposes. If the scheduled repayment amount is low, borrowers can stock their deposits for their next purchase.
Borrowers can also claim benefits of the next financial year by paying the interest of the upcoming year in the current year
There is a possibility that you (borrower) may end up at a tighter budget or exceed your financial ability to pay back at the time of conversion of an IO to a P&I if the interest rates or living expenses shoot up during the IO period. You can’t use your intention of asset sale in order to repay debt as lenders will only consider your ability to finance your loan balance including extended IOs. One more disadvantage of IO is that you’ll be burdened with negative equity if your investment value drops.
Let’s suppose, on the same $500,000 home loan for 25 years at the same interest rate of 4% with an interest-only period of 10 years, you’ll be paying $73,964 more and the amount you’ll be paying for interest will be much higher; $368,719 for 25 years.
Therefore, on the face value choosing interest repayments will generally lead to higher costs overall compared to principal and interest repayments. However ultimately it’s about assessing your situation logical for owners as paying interest will be faster but in situations where you want to increase your cash flows; for investors, interest-only loans generally work o