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P&I or IO repayments?

Jun 6, 2009 by Craig Vaughan
 Principle and Interest v Interest Only Repayments
When taking out a home loan there are many decisions that need to be made.  What bank, whether to go fixed or variable, whether to pay weekly or monthly… One of these decisions is whether to pay principle and interest or interest only which will be the subject of this months post.
 
What are Principle and Interest and Interest Only Repayments?
When you take out a home loan the bank does a calculation to work out what you would need to pay every month (or week or fortnight) to pay the loan back in 30 years, and this naturally becomes your minimum payment.
 
Interest Only repayment: With interest only all you are doing is paying the interest that the bank is charging but nothing off the actual home loan (or principle).  As you are paying nothing off your principle your repayment will be less than a principle and interest repayment (whilst on an interest only period).
 
Principle and Interest repayment: Here, you are paying both the banks interest and also paying off the home loan (principle). This is best explained by example.
 
Example: Craig buys a house and takes out a loan for $400,000.  If Craig was getting a rate of 6% he would have the choice of either principle and interest or interest only repayment.
 
Interest only: The interest only repayment would be circa $2000 per month.  If
Craig took interest only for 5 years and did not make any extra repayments over and above this, then at the end of the 5 years he would still owe $400,000 as he has paid nothing off the principle.
 
Principle and Interest: If Craig was to pay the above loan principle and interest then the repayment would be circa $2398 per month (which would pay the loan out in 30 years).  At the end of month 1, $2000 goes to the interest and $398 would pay go off the principle so now Craig would owe $399,602 ($400,000 – $398).  As the loan continues the interest component will get smaller because its being calculated on a smaller loan amount and therefore a greater portion of the $2398 payment is going to pay off the principle.
 
Should I take interest only or principle and interest?
If its an investment loan and the interest is tax deductible, and you have other debt that is not tax deductible, most accountants would advise to pay interest only on the investment loan and any principle payments should go to any non deductible debt (like your owner occupied home loan or perhaps your car loan).
 
Can I make extra repayments while on interest only?
While on interest only you are permitted to make extra repayments (limits apply if on a fixed rate).
 
How long can I take an interest only period for?
As a rule you can do interest only for a maximum of 5 years however often at the end of the 5 years you can switch to another 5 year period.  Some lenders however permit up to 15 years interest only repayments.
 
What happens when an interest only period ends?
It is important to note that once you come off an interest only period your principle and interest repayment will be higher than what it would have been if you started on principle and interest from day 1.  This is because you now have a shorter time frame to pay the principle off.  Eg, if Craig took 5 years interest only, once the 5 years was up his repayments would switch to principle and interest.  As the loan term is 30 years Craig only has 25 years left to pay off the $400,000 which means he would need to make a monthly payment of $2577 per month to ensure it was paid out in time.
 
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