Interest only vs principal and interest: what each costs, and when lenders allow it

What is a principal and interest loan?

A principal and interest loan, often written P&I, is a home loan where every repayment pays that month's interest and some of the loan itself, the principal. What you owe falls from the first repayment, and the loan is fully repaid by the end of its term.

It's the default way a home loan is repaid, and lenders often set their highest limits for it. CommBank, for example, allows a higher share of the property's value on principal and interest than on interest only (part 11) [1].

What is an interest-only loan?

An interest-only loan is a home loan where, for a set time, each repayment covers the interest and nothing else. The balance doesn't fall: after five years of interest only on $600,000, you still owe $600,000.

When the period ends, the loan becomes principal and interest for the years that are left. On a home you live in the period is usually up to five years; on an investment it can be longer. CommBank allows up to 15 years over the life of an investment loan (part 10) [2].

Interest only vs principal and interest: what's the difference?

The difference between interest only and principal and interest is what each repayment pays for. One pays the interest and some of the loan; the other pays only the interest, for a while. Here they are side by side; part 5 puts dollars on them.

Where does each principal and interest repayment go?

Each principal and interest repayment goes mostly to interest at first, and mostly to the loan by the end. On $600,000 at 6.00%, the first repayment of about $3,597 is $3,000 of interest and about $597 of loan. The split turns as the balance falls, and from year 19 more of each repayment pays off the loan than pays interest [9].

What this means for you: the early years of principal and interest can feel as if they barely move the loan, but they're the years that set up the rest. Five years of interest only skips about $41,700 of loan repayment in this example, and the next 25 years have to make it up.

How much more does interest only cost?

Interest only costs more than principal and interest over the life of the loan, because you owe the full amount for longer. On the illustrative $600,000 loan over 30 years at 6.00%, five years of interest only saves about $597 a month at first and costs about $44,700 more in interest over the loan [9].

This is an illustration, not a quote. Real rates differ, and interest-only rates are often higher than principal-and-interest ones, which widens the gap. Every 0.10 of a percentage point on $600,000 is about $50 a month of interest.

Where does the extra interest come from?

The extra interest on an interest-only loan comes from two places. In the first five years you pay $180,000 of interest, against about $174,200 on principal and interest, a gap of about $5,800, because the balance never falls. The bigger part, about $38,900, comes afterwards: the full $600,000 is still owed and is repaid over 25 years instead of 30 [9].

So most of the cost of interest only lands after the interest-only years, when the lower repayment is long gone. That's easy to miss if you only compare the first-year repayments.

What happens when the interest-only period ends?

When the interest-only period ends, the whole loan has to be repaid over the years that are left, so the repayment rises above what principal and interest would have cost from the start. In the example, it goes from $3,000 to about $3,866 a month, an increase of about $866, overnight. That's also about $269 a month more than the principal and interest repayment would have been all along [9].

You can ask to extend the interest-only period, but it's a new application: the lender assesses you again, at its rules on the day, and may say no.

Does a shorter interest-only period cost less?

A shorter interest-only period costs less, and the step-up at the end is smaller. On the same $600,000 loan at 6.00% over 30 years, here's what each length of interest only does [9].

The cost grows faster than the years. Ten years of interest only costs more than twice what five years does, because the loan is repaid over 20 years instead of 25.

What if rates are higher when interest only ends?

If rates are higher when interest only ends, the step-up is bigger, because the new repayment is worked out on the full balance at the new rate. Here is the same $600,000 loan after five years, if the rate has risen [9].

What this means for you: the question isn't only whether you can pay the step-up at today's rate. It's whether you could pay it if rates were a point or two higher on the day the interest-only years end.

How long can a home loan be interest only?

A home loan can usually be interest only for up to five years on a home you live in, and for longer on an investment. CommBank's limits, for example, are up to 5 years over the life of an owner-occupied loan and up to 15 years for an investment loan, as long as at least 5 years remain on the loan's term [2].

Anything beyond the first period, whether it's longer or a second period after the first ends, means asking the lender again. It's a new application, assessed at the lender's rules on the day.

When will a lender allow interest only?

Lenders allow interest only on tighter terms than principal and interest. Many set a lower maximum loan size against the property's value. CommBank's lending policy allows interest only up to 80% of the value on a home you live in, and up to 90% on an investment, with lenders mortgage insurance (LMI) above 80% [1]. LMI is insurance the lender takes out, and you pay for, when you borrow more than 80% of the value. Its owner-occupied interest-only rates are only for loans under 80% of the value [2].

The product matters as well as the lender. Bendigo Bank's Flex Home Loan reaches 95% of the value only for owner-occupiers on principal and interest [6]. So a loan that would be approved at 90% or more on principal and interest may not be on interest only.

What this means for you: if you plan interest only with a small deposit, the list of lenders is shorter before anything else is looked at. Decide the repayment type before you pick the lender, not after.

Can you get interest only on a home you live in?

You can get interest only on a home you live in at some lenders, but usually with a bigger deposit than principal and interest needs. At CommBank, interest only on an owner-occupied home stops at 80% of the value, and the interest-only period is up to 5 years [1][2].

People living in the home usually ask for it to cover a season: a build, parental leave, or the gap between buying and selling. Part 17 sets out when that can make sense.

Does interest only change how much you can borrow?

On the illustrative $600,000 loan over 30 years, a test rate of 9.00%, 3 points above the illustrative 6.00%, puts the principal and interest repayment at about $4,828 a month, against about $3,597 at 6.00% [9]. See how much can I borrow.

Can you get an interest-only investment loan?

Yes, you can get an interest-only investment loan, and lenders often allow more room for it on an investment than on a home you live in. CommBank, for example, allows interest only up to 90% of the value on an investment, against 80% on a home [1], and up to 15 years of interest only over the loan [2]. Investors use it to keep repayments down while they hold the property, and to keep spare cash free for other things, such as paying down the home they live in.

Tax is part of why investors weigh it, and it's a question for your accountant, not a broker. The ATO's ruling TR 2000/2 on redraw and line-of-credit facilities is where your accountant will start [8]. The way an investment loan is set up, and what you pay into it, is worth raising with them before you settle. See debt recycling and using equity to buy an investment property.

Can you have an offset account on an interest-only loan?

Yes, you can have an offset account on an interest-only loan, where the loan offers one. An offset account is a savings account linked to your loan: the money in it is taken off the balance before interest is worked out. On interest only, an offset lowers the repayment itself; on principal and interest, it shortens the loan.

With $50,000 sitting in an offset against the illustrative $600,000 loan at 6.00%, interest is charged on $550,000. On interest only, the repayment falls from $3,000 to $2,750 a month, and the balance still doesn't move. On principal and interest, the repayment stays at about $3,597, but more of it pays off the loan: kept at $50,000 throughout, the offset would clear the loan about 4 years and 8 months early and save about $202,000 of interest [9].

Money in an offset isn't a repayment, so taking it out isn't a redraw. For an investment loan, put the difference to your accountant before you choose between paying extra in and holding it in an offset (part 15).

When can interest only make sense?

Interest only can make sense for a short period of lower repayments with a clear end, and for some investors with a clear plan for the loan. Common cases are a build, parental leave, or bridging between selling one home and buying the next.

Some loans are interest only by design. A construction loan usually charges interest only on what's been paid out to the builder so far, until the home is finished; see construction loans. On a bridging loan, Firstmac's policy has no repayments in the first six months; on its 12-month bridge, months 7 to 12 need monthly interest-only repayments on the peak debt, and you must show you can afford them [7]. See bridging finance.

When is principal and interest the better choice?

Principal and interest is usually the better choice for a home you live in, for anyone who wants the loan to shrink from the start, and for anyone who'd struggle with the step-up. It costs less in interest over the loan and builds equity from the first repayment.

It's also the repayment type lenders often give their highest limits and waivers to (parts 11 and 14), so a buyer with a small deposit often has more lenders to choose from on principal and interest.

What happens to your equity if property values fall?

If property values fall, an interest-only loan leaves you with less equity, because none of the loan has been paid off. Equity is the property's value less what you owe. Take a $750,000 home bought with a $600,000 loan, 80% of the value, and a 10% fall in value after five years [9].

Above 80% of the value, lenders mortgage insurance normally applies [10], so the interest-only borrower in this example would usually face LMI to refinance, and a narrower choice of lenders. The principal and interest borrower is also over 80%, but by less, and closer to getting back under it.

Can you switch between interest only and principal and interest?

You can switch between interest only and principal and interest, but the two directions aren't the same. Moving to principal and interest early is a request to pay more; asking for interest only, or for more of it, is a new application that the lender assesses at its rules on the day.

Ending interest only early cuts the cost. On the illustrative loan, two years of interest only instead of five costs about $17,100 in extra interest rather than about $44,700 (part 8) [9]. Ask your lender how it handles the change, and whether any fixed rate on the loan affects it.

What does a broker cost you?

How a broker is paid, and the rule Money Brain holds against it, is set out in full on its own page: what a mortgage broker costs.

Your first move

You've seen the dollars both ways. Now there's one question left: on your loan, at your deposit and your income, which repayment type do the lenders that suit you allow, and what does the step-up look like at a higher rate? That's what Money Brain works out before anything goes to a lender.

When you're ready, the closing section below is the simplest way to start.