When you are in the market to buy a home, you’ll realize pretty quickly that there are a lot of important decisions to make. One of the most fundamental of those decisions involves how you want to repay the loan used to purchase your property.
When it comes to home loans, there are two main options for repayment: “principal and interest” or “interest-only.” Both options offer distinct benefits that are meant to serve different circumstances. Since your choice of repayment will have a big impact on your finances, you want to be sure that you are selecting the payment terms that make the most sense for your situation.
Below, we’ll explain the difference between principal and interest and interest-only home loan payments as well as who benefits the most from each option.
The difference between principal and interest and interest-only home loans can be summed up in one sentence: when do you need to start paying off the principal? With a principal and interest loan, you will be making regular payments right from the start to reduce both the principal (the amount of money that you borrowed) and the interest (the fee charged by your lender to borrow the money). On the other hand, with an interest-only loan, you will have the option to defer payment of the principal for a certain period (usually between 3 to 5 years). During this time payments would only cover the interest generated on the loan. Once the interest-only period is up, you will need to start repaying the principal as well.
During the interest-only period, your repayments will likely be lower than those of a comparable principal and interest home loan. This changes, however, after the interest-only period comes to an end. At that point, your monthly payments will likely be higher than those of a comparable principal and interest loan.
Not only will the monthly expenses be higher on an interest-only repayment, but you will also end up paying more interest over the duration of the loan. This is due to the fact that even though the principal is not being repaid right away, it still accrues interest.
To see these differences in action, let’s take a look at an example:
Say you take out a standard principal and interest loan of $400,000, with an interest rate of 5%. You will have a monthly repayment of $2,338, and the total interest payable on the loan after 25 years will be $301,508. With an interest-only home loan that has a 5 year interest-only term, for the first 5 years your monthly repayment will be $1,667. Once the term is up, monthly repayments will jump up to $2,640, and the total interest payable on the loan after 25 years will be $333,558.
So, should you immediately start to repay the principal or just the interest on your home loan? The answer to this question really depends on why you are buying the property in the first place and as well as your particular financial circumstances.
A principal and interest repayment option is the home loan of choice for those who plan on living in the home and/or those who want to own their home entirely. Even if you end up selling the property before the repayment term is up, you will be growing your equity in the property since each repayment reduces the principal amount that you owe.
On the other hand, investors seeking to resell a property within a few years usually want the interest-only repayment option since monthly repayments are reduced at the beginning. Investors may also be able to claim the interest paid on the home loan as a tax deduction if the loan is being used to purchase a residential investment property generating rental income.
In short, the choice between a principal and interest or interest-only home loan will depend on whether you’re looking to own the property outright or are teating it as an investment.