When it comes to paying off your home loan, you’ll be able to choose between two options: pay off both the principal and interest, or pay interest only.

What you decide will depend on your reasons for buying the property as well as your financial circumstances. For a breakdown of what you need to know about each repayment type and what they mean for owner occupiers and investors, read on below.

Principal and interest loans

As the name suggests, principal and interest loans require borrowers to pay off their principal balance and the interest it accrues at the same time.

While this means you’ll be making larger home loan repayments than you would on an interest-only loan, by doing so you can grow equity in your property and reduce the amount of interest you’ll pay in the long run.

When you take out a home loan, your lender will calculate the minimum principal and interest repayments you’ll be required to make at regular intervals. They will also specify the loan term – typically no more than 30 years – in which it will have to be repaid.

Advantages of P&I repayments

Lower interest rates: paying both the principal and interest on a loan makes you less of a risk in banks’ eyes, so you’ll be offered cheaper rates than you would be on equivalent interest only loans.

Pay less interest overall: since your scheduled repayments chip away at both the principal amount and the interest owed, you’ll wind up paying less interest over the life of the loan than you would with an interest-only loan.

What are the rates like for owner occupiers and investors?

P&I loans for owner occupiers: If you’re buying a home you intend to live in yourself, you’ll be considered an owner occupier and your lender will probably give you a slightly cheaper rate than it would investors. At the time of writing, the average variable rate for owner occupiers making P&I repayments is 3.25% p.a.

P&I loans for investors: If you’re taking out a loan to purchase an investment property, keep in mind that you’ll likely have to pay a higher interest rate than if you were an owner occupier. Currently, the average variable rate on investment home loans is 3.64% p.a.

Interest only loans

On an interest only loan, borrowers will pay down just the interest portion along with any associated fees for a fixed amount of time (usually no more than five years). Since your repayments won’t go towards paying off the principal, it will remain the same unless you choose to make extra repayments.

Once the interest-only period expires, you’ll have to start making principal and interest repayments, which can be significantly higher depending on how many years remain on your loan.

While interest only loans tend to be associated with property investors, they can also be useful for other types of borrowers too. Here are just a few ways that you can benefit from making interest only repayments.

Advantages of IO repayments

Smaller repayments: If your budget suddenly tightens or you lose an income stream, switching to interest only repayments for a period of time can provide significant, albeit temporarily, financial relief.

Tax incentives: If you’re an investor, interest only loans can help maximise cash flow and free up money for further investment. You’ll also be able to claim tax deductions against the interest paid on your loan.

Disadvantages of IO repayments

The principal stays the same: While your repayments will be lower for the time being, the principal amount will continue to collect interest, which means you’ll pay more over the life of the loan.

You’ll have to make up the repayments: Once the interest only period ends, your lender will adjust the terms of your loan to make sure you’re still able to pay it off in time. The sudden jump in repayment size might come as a shock if you’re not prepared.

Source: Niko Iliakis