When we make repayments on our home loan, we can do it either one of two ways. We can make principal and interest repayments or interest-only repayments.
The principal is the amount of money you borrowed from your lenders, while interest is the money charge on top of it. It is calculated based on the interest rate and the size of the principal. Most home loans require you to make principal and interest repayments. This means your repayments cover both principal and interest.
What is principal and what is interest?
Your home loan’s principal is the amount of money you borrow from your bank or lender. On the other hand, the interest is the cost charged by your bank or lender to you to borrow the money.
Your home loan’s interest rate, loan term and repayment amount will determine how much you’ll end up paying back over the duration of your loan.
Principal and interest repayment
When you take out a principal and interest home loan, you’ll repay both the loan’s interest and the amount borrowed (principal) at the same time.
One of the benefits of choosing a principal and interest home loan is that your repayments will be lower over the duration of your home loan. Each time you pay the minimum repayment you’re simultaneously gradually paying off the principal loan amount and paying off the interest.
The lender will usually work out the minimum principal and interest repayments needed to repay the loan within the selected term.
Things to consider
By making Principal and interest repayments, you’re paying off the mortgage earlier in the term which means you’ll end up paying less in interest.
Here’s a list of things to keep in mind:
- Higher borrowing power
Most lenders restrict interest-only loans to 80% of the property value (some up to 90%). On the other hand, if you chose P&I you can potentially borrow up to 95% or even 105% with a guarantor.
- Reduced interest rates
By choosing P&I repayments, you make a lower risk for lenders than a borrower making interest-only repayments. That’s why banks are willing to offer you cheaper interest rates.
- Potentially pay off the home loan early
P&I repayments might be more costly but it means you’re paying off principal and interest in your home loan, saving you thousands over the long term.
- You’re actually paying off the loan
With interest-only repayments, your repayments might be smaller but you’re not paying off the loan itself.
- There will be no sudden increase in repayments
The sudden increase of repayments once the interest-only period ends might affect your well-structured cash flow plan.
- A lot easier to refinance
If you choose P&I, refinance is a lot easier.
- You’re building equity faster
P&I allows you to maximise your property’s equity growth and avoid negative equity by further reducing your principal.