HOME LOAN PRINCIPAL AND INTEREST OR INTEREST ONLY

Different loan repayment types :

When you apply for a home loan, you may have the option of one of these repayment types :

• Principal and Interest Repayments
• Interest-only Repayments

It’s important to understand how these different types of loan repayments work and how they can change over time. Each has its advantages and disadvantages.

What is the ‘principal’ and what is ‘interest’?

As mentioned above your home loan is made up of two parts, the principal and the interest, both are described as under :

• The principal is the amount you borrow.
• The interest is the amount you’re charged by the lender for borrowing the principal amount.

Generally, when you make a loan repayment, your repayment pays down some of the principal amounts as well as the interest accrued. This is known as principal and interest repayment.

However, you may be able to choose to make interest only payments for a specific period, so you’re only paying interest charged. This means your payments during that period will be lower than principal and interest repayments. Because you eventually have to repay the principal balance.

You need to consider your financial situation to plan for the end of your interest only period, when you switch to principal and interest repayments, as your repayment amount will be higher.

Here’s what you need to know about the two most common types of loan repayments.

Principal and Interest Repayments

If you have this type of home loan, you’ll need to pay both the principal as well as the interest charged on it.

Advantages of a Principal and Interest Loan

• Pay less interest over the life of the loan.
• Pay a lower interest rate compared to interest-only rates for an equivalent home loan.
• Pay off your loan faster, so you’ll own your property outright sooner.
• You will be paying down your principal balance (as well as interest it accrues) from your first repayment.

Disadvantages of a Principal and Interest Loan

• Repayments are higher than interest only.
• May not be as tax-efficient for investment loans.

Interest-only Repayments

This is when you only pay the interest portion of your loan for a set period of time, for example the first five years of your loan. As you’re not making payments on the ‘principal’, this will remain the same, unless you choose to make additional repayments. At the end of your interest-only period, you’ll need to start paying off the principal at the current interest rate at that time.

While interest-only repayments are lower during the interest-only period, you’ll end up paying more interest over the life of the loan.

Advantages of interest-only loans

• Lower mortgage repayments for a limited time to suit your lifestyle.
• Possible tax benefits for investment loans.

Disadvantages of interest-only loans

• Principal amount will not reduce during interest-only period
• Higher repayments once the interest-only period finishes
• Higher interest rate during interest-only period
• More interest payable over the life of the loan.

When your interest only loan comes to an end

When the interest only period expires, your repayments will change to principal and interest. This usually means your repayment amount will increase as you will now be repaying principal as well as paying interest on your loan.

How does principal and interest work?

In a Principal and Interest loan, the principal (original amount borrowed) is divided into equal monthly amounts, and the interest (fee charged for borrowing) is calculated on the outstanding principal balance each month. This means the monthly interest amount declines over time as the outstanding principal declines.

Case study of two loan repayment types

See how the two types of loans affect Sam and Sonia repayments.

Sam and Sonia have a loan of $ 5, 00,000 and are deciding which repayment option is suitable for them.

The table shows the difference in interest they will pay over the life of their loan.

Positives of a Principal and Interest loan

It is essentially a “forced saving” repayment which means you are paying your loan off from day one. If you pay the bare minimum, you pay less interest over the term than an Interest-only loan. Your interest rates can be cheaper in some circumstances.

The choice between P&I and IO usually depends on the size of the loan, the cost of setting up the loan, tax considerations and your financial strategy.

There is a lot more to this decision than meets the eye. If you want to get a better grasp of the situation and make an informed decision, contact our financial expert Parag Dixit at Greenshoots wealth.