Interest only or Interest and Principal?
Your home loan is made up of two components – the principal and the interest. The principal is the actual amount you have borrowed, while the interest is the cost charged by your lender to enable you to borrow the money. The interest is calculated by the size of your principal, so as you reduce the principal, your interest payments will also become lower. Your lender will set a specified term for you to repay the loan – this is normally around 30 years.
There are two options for paying off your home loan – you can pay off the interest only or you can pay both interest and principal. Both these options have their advantages and disadvantages, and it is important to assess these pros and cons based on your long-term investment strategy.
With an interest-only home loan, you only need to pay the interest on the loan for a specified period of time, usually a maximum period of five years. This makes it a good option for buyers who have purchased the property as an investment and intend to sell within a few years. By only paying the interest, you have lower monthly repayments, minimising the amount of capital you need to invest in the property, plus you have the advantage of claiming the interest payments as a tax deduction. As your repayments are lower, you also have the option of investing other funds elsewhere
The interest-only loan may also be an option for the first home owner who wants to reduce monthly repayments for a preliminary period, to recover from all the costs of purchasing the home in the first place. However, this is not a good option, as you will ultimately pay more in interest over the term of your loan. And the smaller interest-only repayments are not good preparation for the shock of inevitable principal and interest payments.
Another disadvantage to the interest-only loan is that if your property depreciates, your debt could exceed the property value.
Interest and Principal
Your repayments will be bigger with an interest-and-principal loan, but you are also reducing the size of your loan, and thereby reducing interest repayments over the long term. You are building equity in the property, and your overall payment will be lower over the life of the loan. However, in the short term, these repayments can seem like a huge expense. Before purchasing a property, calculate the maximum you can comfortably pay each month, so you can
build equity in your property without stressing too much about the size of your loan repayments.
While interest-only can be a good option for investors, it is not a cost-effective option for long-term home owners. Talk to your mortgage broker or financial adviser to work out how much you can afford to borrow to ensure your payments will be manageable, and you will get the best value from
your property investment.