Principal And Interest Home Loans

Find all the essential information you need to know about principal and interest home loans and how to save on your mortgage with Savvy.

Last updated on April 20th, 2022 at 11:26 am by Cate Cook

Principal and Interest Loans

You might’ve heard the term ‘principal and interest loan’ in the past, but haven’t known exactly what it meant. The majority of home loans in Australia are principal and interest loans, but knowing how these elements work can help you compare and choose the loan that’s most appropriate for you, potentially saving you tens of thousands of dollars over the life of your loan.

There are also many other additional features and options offered by lenders with their principal and interest loans, so read on to find out how interest is calculated and discover the different ways that you can compare with Savvy to help find the cheapest home loan available to you.

What factors should I look at when comparing principal and interest home loans?

There’s a variety of factors to take into account when separating the best principal and interest home loans from the rest.  No two lenders are the same when it comes to their interest rates, fees or charges, so comparisons are very useful.  Here are some areas to look at when you compare principal and interest home loan deals, which you can do right here with Savvy.

The type of lender you prefer

The lender you choose will shape your loan repayment experience considerably, so you should consider all the different options carefully. Choose from: 

  • Banks: banks (particularly the biggest ones) offer a wider range of products than other lenders, but interest rates, fees and charges may not always be the most competitive on the market.
  • Credit unions: these operate very similarly to banks, but as they’re non-profit and owned by their members, they channel profits back into the credit union, which often manifests itself in lower interest rates and reduced fees.
  • Online or non-bank lenders: these lenders are smaller than banks and credit unions and often offer a cheaper, specialised service to you. They’re not regulated in the same way as banks, though, and usually don’t have any physical locations.

Interest rate offered

A seemingly insignificant interest rate difference can amount to hundreds or thousands of dollars over the life of a loan.  For example, a $500,000 loan paid over 30 years with a 3% interest rate will end up costing you just under $760,000.  An interest rate of 2.8% could save you almost $20,000.

Comparison rate

Home loan comparison rates are calculated based on a $150,000 loan over a 25-year loan term.  A loan’s comparison rate indicates how much you’ll be paying in interest, but also in additional costs, painting a more accurate picture of the true cost of your mortgage.  Lenders are legally required to display a comparison rate when advertising their loans.   These rates include primary upfront and ongoing costs, as well as a revert rate if you’re signing onto a fixed rate or introductory rate loan.

Repayment terms and frequency

You get to shape the cost and affordability of your repayments in several ways. Firstly, you can choose the term over which to repay your loan, with repayment periods available up to 30 years enabling you to set your instalments at a manageable level. You can also decide on whether to pay monthly, fortnightly or weekly, depending on which suits you the most.

Additional features on offer

Lenders will often sweeten their loan deals by throwing in bonus features that can improve your repayment experience. These may include:

  • Offset accounts: an offset account is a feature which allows you to reduce your principal more quickly, and therefore the interest you pay overall. You’ll be able to do this by depositing your existing funds in an account that’s linked to your mortgage, essentially serving as an interest-free contribution to your loan principal. 
  • Additional payments: some loans may charge you a fee to make additional payments, but if you’re able to do it for free, you can cut down your principal far more quickly.
  • Redraw facilities: this feature allows you to access additional repayments you’ve made and withdraw them. It can help if you’re suddenly faced with an unexpectedly large bill or have to cover emergency costs.

What is an interest-only home loan?

Interest-only home loans are the main alternative to principal and interest loans.  The borrower spends the first portion of their loan (usually one to five years) solely paying interest and the remainder paying off both principal and interest.

This method of repayment is advantageous for those who have tight cashflow, allowing their principal payments to be deferred to free up extra funds in the short term.

Interest-only home loans are also a popular choice for property investors. The reduced repayments for the first part of the loan can enable them to free up funds, and may allow investors to claim more in tax deductions from their investment property.

However, this type of loan will cost considerably more in interest over the life of the loan because while you’re exclusively paying interest, the principal sum you borrowed isn’t reducing.  It may feel like you’re making inroads into your home loan, but in financial terms, you’re standing still.

Interest-only home loans are the main alternative to principal and interest loans.  The borrower spends the first portion of their loan (usually one to five years) solely paying interest and the remainder paying off both principal and interest.

This method of repayment is advantageous for those who have tight cashflow, allowing their principal payments to be deferred to free up extra funds in the short term.

Interest-only home loans are also a popular choice for property investors. The reduced repayments for the first part of the loan can enable them to free up funds, and may allow investors to claim more in tax deductions from their investment property.

However, this type of loan will cost considerably more in interest over the life of the loan because while you’re exclusively paying interest, the principal sum you borrowed isn’t reducing.  It may feel like you’re making inroads into your home loan, but in financial terms, you’re standing still.

Case study: principal and interest loans vs interest-only loans

You take out a home loan of $300,000 with a loan term of 30 years and an interest rate of 2.85% p.a.  You intend to make monthly repayments.

Principal and Interest (P&I)

You elect to pay your loan back with P&I payments.  In this case, you’ll be paying your lender $1,241 each month for the duration of your home loan.  Throughout your loan, your repayments will total $446,642.

Interest-Only

If you choose a loan with an interest-only period of five years, it’s a different story. During the interest-only period, your monthly repayments will be only $713. However, once this ends and you begin paying both principal and interest, your loan will cost $1,399 per month.  The result over the course of your loan is that you’ll pay a total of $462,552, meaning that you’d have paid almost $16,000 more than you would’ve on a P&I loan.

The pros and cons of principal and interest loans

PROS

Gradual reduction in the principal you owe

You’ll be paying down your loan principal at the same time as paying the interest charged on your loan amount.  Towards the end of your loan, a greater proportion of your repayments will go towards reducing your principal.

Interest reduces each month

As the principal you owe reduces, so too does the amount of interest you pay each month. Because you’re paying both principal and interest from the start, you’ll pay less interest overall.

Lower interest rates

P&I loans generally have the lowest interest rates available and since they’re the most common form of mortgage, you’ll have a large number of loans to choose from a variety of lenders.

Comparison results in stiff competition

Comparison sites have increased the competition between lenders, driving down interest rates and hidden fees. Principal and interest loans are more customer-oriented now than they’ve ever been in Australia, which gives you higher quality options to choose from with Savvy.

Options to pay off your loan sooner

Additional loan features introduced in recent years (such as offset accounts, no-fee offers, the ability to make lump sum payments, and no early exit fees) have introduced many new ways for borrowers to pay off their loan sooner.

CONS

Higher repayments

Your minimum fortnightly or monthly repayments will be higher than if you opt for an interest-only repayment period on your loan.

Fewer tax benefits

Higher income-earners who are looking for tax offsets don’t benefit as much from P&I loans as they do from interest-only loans, and the loan principal isn’t claimable as a tax deduction, so they’re not always the preferred option for property investors.

Common questions about principal and interest loans

Am I able to apply for my home loan online?

Yes – we’re partnered with a range of lenders who operate in the online space. They allow you to complete your application from start to finish via your computer or smartphone, submitting all of your documentation digitally. This allows you to avoid setting time aside for in-branch meetings or phone appointments to complete the whole process. Enjoy the convenience of an online home loan.

Can I still use a P&I loan to buy investment property?

Yes – many investment mortgages are P&I loans. They’re useful for investors looking to keep their property long-term.  Investors may elect to go with an interest-only period if they plan on selling the property, as they’ll pay less during their period of ownership.

Are P&I loans good for first home buyers?

Yes – first home buyers should consider a principal and interest loan first and foremost.  There are many grants and concessions available to help first homebuyers afford their first property, such as the federal government’s First Home Loan Deposit Scheme and your state or territory’s First Home Owner Grant.

Should I get pre-approval for my P&I home loan?

Yes – pre-approval will help you gain an understanding of what size mortgage you can afford.  It’s a non-binding estimate of a borrower’s loan capacity. It’s not compulsory to get pre-approval, but it certainly can help when you approach a sale with pre-approval already arranged, as you will be perceived as a serious buyer.

Can I be approved for my P&I home loan if I’m a casual employee?

Yes – there are lenders who’ll accept your application as a casual worker, as long as you’re borrowing within your means, have a decent credit history and can prove you’ve been in the job for an extended period of time (usually a minimum of six months working consistent hours). Income stability is the main factor that lenders wish to see with casual employees.

Can I still pay off my principal with an interest-only loan?

Yes – you may be able to pay off some of your principal with an interest-only loan if you want to contribute a lump sum additional payment, but it’s not a requirement or expectation of the loan.