Principal & Interest vs Interest Only Repayment – which one is better suited for you?

I often get asked this question so I thought I would write something generic for everyone but what is most suitable for each will depend on everyone’s circumstances so please seek qualified professionals for tailored advice.

Before we jump in let’s understand what these two terms mean:

  1. Principal & Interest (P&I) repayment type means at each repayment a customer will pay off some of the principal (or loan amount), plus the interest calculated based on remaining balance of loan amount. So over time each payment will reduce the outstanding loan balance, and the interest will be less over time.
  2. Interest Only (IO) repayment type means at each repayment a customer will only pay the interest incurred on the balance of loan amount. Each repayment does NOT reduce the outstanding loan amount. The amount of repayment or interest incurred will be dependent on both the outstanding loan balance and the current interest rate.

Now we have a better understanding of the definition of these two repayment types we can look deeper into the reasons that we should choose one over the other. Generally speaking clients seek credit for the following purposes:

  1. To buy a home to live in

For everyday Australians who wants to buy an own home to live in they usually want to be able to pay off the loan as they go. Based on this we recommend to go with P&I mainly for the following reasons:

  • As the property will not be income generating the interest incurred will not be tax deductible. Hence best to pay down the debt and reduce interest payment
  • As principal is paid off they can also build up some equity in the home for the future

Note however, the place is only a temporary home and eventually is to be turned into an investment property it may then make sense to seek IO repayment depending on individual circumstances. The idea of going IO is to be able to maximize negative gearing once the current home is turned into an investment property.

  1. To buy an investment property as part of wealth creation

Investors purchase property for long term wealth creation so they want to minimize the holding cost as much as possible. Based on this goal, for investors we usually recommend to go with IO mainly for the following reasons:

  • Maximize negative gearing – for tax purposes
  • IO repayment amount are usually less than P&I repayment, which means it’ll allow investors to save up deposit quicker for the next IP in the short term. This will allow investor to accumulate the property portfolio quicker.

Note however it is important to understand and plan ahead on how to pay off the debt after IO period expires. The common IO period is 5 years which means by the end of the IO period you’ll have only 25 years to pay off the principal (instead of 30), and the monthly repayment will jump up on average 25 to 30%. This could be a nasty surprise to most people as IO period comes to an end so it is prudent to understand the implications of taking out a loan with IO repayment.

  1. To extract equity of home for various purposes – can be investment, personal purposes etc

When releasing equity the repayment type would depend on the purpose of the fund. If it is a cash out for investment such as purchasing the next IP, then we would recommend going with IO so the available fund doesn’t reduce while you are hunting for a property. Also this would allow you to maximize negative gearing purpose.

However if it’s for non-income generating purpose such as buying a car (which depreciates), then we would generally recommend P&I so that the loan can be paid off gradually while our clients enjoy the benefit.

Is your loan coming up to end of IO period? Is your current repayment structure optimized in the way so you can pay off your non-deductible debt as quickly as possible? Contact us today to organise a finance health check to get your finance structure correct and improve your overall financial position!

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