The principal is the initial amount you have borrowed for the loan, whereas interest is the cost charged by the bank for lending you the money.
Regular loan repayments will typically include an interest payment, plus a partial repayment of the principal - unless you opt for a home loan with interest-only payments.
Allow us to explain…
Principal and Interest repayments
For a home loan with principal and interest (P&I) repayments, you’ll need to pay the principal of the loan as well as the interest charged on it.
The lender will charge interest on your loan based on an annual percentage rate. That rate is divided by 365 to calculate the interest each day on the loan’s current balance. Given that interest is typically charged on a monthly basis, the daily interest amounts for a month are added together to give the total which will be added to the loan balance.
Regardless of whether your principal and interest loan repayments are weekly, fortnightly or monthly - they will pay off the interest as well as a portion of the loan balance. As you are gradually chipping away at the loan amount, the amount of interest that you pay should continue to decrease each month, provided your interest rate doesn’t change. It’s important to note that depending on the number of days in a month, the interest amount being charged can fluctuate.
Interest-only (IO) loans only require you to pay the interest portion of the loan for a set period of time, for instance the first five years of the loan. Given that you aren’t making payments on the principal, the interest charged will stay the same, unless you choose to make additional repayments or the interest rate changes.
You’ll need to start paying off the principal at the current interest rate once the interest-only period has ended. Despite interest-only repayments being lower during the interest-only period, in the end you’ll actually end up paying more interest over the life of the loan.
Pros & cons
Principal and interest
You’ll typically pay less interest over the life of the loan
The interest rate on a P&I loan is usually lower compared to an equivalent home home on an IO rate.
You’ll typically pay off your loan quicker, meaning you’ll have unencumbered ownership over the property sooner.
Repayments are higher than interest only loans.
If you are looking for a suitable investment loan, a principal and interest repayment type may not be the most tax-efficient option.
You’ll have lower mortgage repayments for a limited time, which may be more suited to your current lifestyle.
You may be also be entitled to tax benefits for investment loans.
During the interest-only period, the principal amount will not reduce, meaning you will have high repayments once the interest-only period finishes.
Interest-only loans typically have higher interest rates.
Which is better, principal and interest or interest-only?
Each loan repayment type differs significantly, and there is no one simple answer to this question.
A principal and interest home loan will mean you are paying more upfront. However, over the whole life of the loan you will typically end up paying less interest.
On the other hand, interest-only loans can be much cheaper to start with since the repayments will be much smaller. However, once the IO period is over repayments can jump significantly, which can result in the loan becoming more expensive overall. This option may be more suitable for your lifestyle and needs at the time and therefore could be the better repayment type for you.
Regardless of which repayment type you choose, it’s always important to shop around for a better interest rate and check any additional fees that might be charged by your lender, like establishment fees and annual or monthly fees.
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