When taking out a mortgage, one of the key decisions you’ll need to make is whether to choose a principal-and-interest (P&I) loan or (IO) interest-only loan.
Each loan type has its own structure, benefits, and considerations. Understanding the differences between the two can help you make a more informed decision, one that matches your financial goals and life circumstances.
What is an Interest-Only Loans?
A principal-and-interest (P&I) loan requires you to make repayments that cover both the loan’s interest and a portion of the principal (the original amount borrowed). Over time, this reduces the amount you owe and eventually pays off the loan entirely by the end of the term.
In contrast, with an interest-only (IO) loan, your repayments during the initial period cover only the interest charged on your loan – not the principal. This means your repayments are lower during the IO period. However, once this period ends, your loan switches to a principal-and-interest structure, and your repayments increase accordingly.
Let’s bring this to life with a simple example:
- Imagine you borrow $500,000 over a 30-year term with an interest rate of 6% p.a.
- Under a P&I loan, you would pay around $2,998 per month, leading to total repayments of about $1,079,191 over the full 30 years.
- If you chose an IO loan with the first five years interest-only, your monthly repayments during that initial period would be lower – about $2,500 per month.
- However, once the loan reverts to P&I for the remaining 25 years, your repayments would jump to around $3,222 per month, and your total repayment over 30 years would be higher – approximately $1,116,452.
Clearly, there are short-term savings but potentially higher long-term costs involved.
The Pros and Cons of Interest-Only Loan
As with any financial product, there are both advantages and drawbacks to consider when thinking about an IO loan.
Advantages:
- Lower initial repayments:
During the interest-only period, you’ll enjoy smaller monthly repayments compared to a standard principal-and-interest loan. This can help manage your cash flow, especially during financially tighter periods. - More financial flexibility:
The money you save on repayments can be redirected towards other expenses, investments, or even building a financial buffer.
Disadvantages:
- Higher repayments later:
Once the interest-only period ends, your repayments will rise because you’ll have less time to pay off the principal. - More expensive overall:
You’ll end up paying more interest over the life of the loan because the principal remains unpaid for a longer time. - Higher interest rates:
Lenders often charge slightly higher interest rates for interest-only loans compared to standard P&I loans.
Why Some Borrowers Choose Interest-Only Loan
Despite the drawbacks, interest-only loans can be a smart option in specific circumstances. Here are three common reasons why borrowers may choose them:
1. Preserving Cash Flow
Borrowers with limited disposable income at the time of taking the loan might prefer to keep their repayments low initially. This might include entrepreneurs waiting for a new business to grow, households where one partner is temporarily not working, or families managing significant expenses. The idea is that future income will improve, allowing for higher repayments later without financial strain.
2. Maximising Tax Benefits for Investors
Interest-only loans are particularly popular with property investors. In Australia, investors can claim a tax deduction for the interest paid on their investment loans. Since principal repayments aren’t tax-deductible, it makes sense for some investors to minimise their outgoings in the early years, while maximising their tax benefits and potentially building equity through capital growth.
3. Short-Term Ownership Plans
Some borrowers take out a mortgage with the intention of selling the property within a few years – for example, during a property market upswing. For these buyers, an interest-only loan can limit their monthly expenses while they own the property, increasing overall flexibility.
Key Things to Consider
Before deciding if an interest-only loan is right for you, it’s important to think through your long-term plans and financial position.
- How will you manage the higher repayments later?
Make sure you have a plan in place for when the IO period ends, whether through expected income growth or savings. - What are your investment goals?
If you’re purchasing an investment property, consider how an IO loan fits within your broader investment strategy. - What will happen if interest rates rise?
A rise in interest rates can have a greater impact on repayments once the loan reverts to P&I. - How long do you plan to hold the property?
For short-term ownership, an IO loan might make sense. For long-term ownership, the cost difference over the full loan term could be significant.
How Gold Finance Group Can Help
Choosing between a principal-and-interest loan and an interest-only loan can feel overwhelming — but you don’t have to do it alone.
At Gold Finance Group, our experienced mortgage brokers are here to help you weigh the pros and cons based on your personal circumstances. We’ll help you understand not only the numbers today but also how they will evolve over time, ensuring you make a choice that supports your long-term financial wellbeing.
If you’re ready to explore your mortgage options or simply want expert advice tailored to your needs, get in touch with the Gold Finance Group team today.
Your financial success starts here