Which loan is the right one for you?

One of the big decisions a homebuyer or investor needs to make is what type of loan to have on their property. 

In years gone by, the vast majority of people choose principal and interest loans, believing that the key to financial freedom was paying off their home loans — regardless of whether they were owner-occupied or investment properties. 

Your parents probably taught you something like… get a  good education, get a  good job, buy a home and slowly pay it off.

Remember that?

These days, however, borrowers are becoming more educated about their finance options.

There are good reasons why most investors choose interest-only loans and why homeowners often choose principal and interest.

To help you understand the key differences, it's important to be familiar with the basic mechanics of how each loan works.

So, as an example, let's take a look at a $400,000 home loan, with an interest rate of five per cent, and then compare the differences between the two loans.

Interest only loan  

Interest-only loans are the easiest to calculate, given we simply multiply $400,000 by five per cent, which equals an annual interest bill of $20,000 that can be paid back either weekly, fortnightly or monthly.

Let's say you repay it monthly, which would be $1,666.67 worth of interest per month.

Of course, it's important to understand that by paying interest-only, you never actually pay down the principal loan amount, instead you're just covering the interest component.

Principal and Interest

Calculating principal and interest repayments is slightly more tricky because it involves paying off the loan in entirety over a 25- or 30-year period.

If we use a 25-year repayment timeframe as an example, then there will be 300 months in that period of time for the principal and interest to be repaid. 

If we look at the $400,000 mortgage again over a 25-year period, the first of the 300 monthly loan repayments would be $2,338.36 — that’s $671.69 more than an interest only loan.

The extra you are paying is for slowly reducing your principal — the amount owing on your loan.

If we follow this logic, then each month the amount of principal we are paying off is slowly getting greater and greater, until the very last repayment is technically all principal and no interest.

If we take a look at the same scenario but increase the term of the principal and interest loan to 30 years, then the monthly repayment is slightly less: $2,147.29.

This includes an even smaller component of principal that's being paid off each month because you’re paying it off over a longer term.

So with a principal and interest loan, ideally you'd want to pay it off sooner rather later as it will reduce the total amount of interest that you'll end up paying the lender. 

Some people do this by paying extra lump sums off their loan, while others find by making fortnightly rather than monthly payments they sneak an extra payment in each year and this pays down the loan just that little bit sooner.

Obviously, if you have an interest-only loan, no principal is ever repaid, and therefore you are not making any progress towards repaying your loan.

However, in the case of a loan against an investment property, many investors prefer to pay interest-only because the lower repayments leave them more cash for other purposes such as to repay their home loan or perhaps to put in an offset account and eventually use as the deposit for their next investment property.

Of course, as only the interest component of your investment loans is tax deductible, it makes sense to maximise this tax benefit.

What about home owners?

Now contrary to normal financial advice, I’d also recommend home owners consider an interest only loan.

In my mind it’s better to use the surplus cash from the lower loan repayments of a P & I loan to service the debt on a well located incoming producing investment property that grows in value. 

To me this makes more sense than waiting until you’ve paid off your home before buying an investment property.

In time your both you home and your investment property will grow in value and the original mortgage will be a smaller proportion of the total value of your property.

Once you’ve built an asset base of a number of investment properties it’s worth considering switching to principal and interest and slowly repaying debt to lower your loan to value ratios.

Whether an interest-only or a principal and interest loan is the right one for you, it's important to access all the information and support you need so you can make an educated choice which will benefit you over the long-term.

About Michael Yardney Michael is a director of Metropole Property Strategists who help their clients grow, protect and pass on their wealth through independent, unbiased property advice and advocacy. He's once again been voted Australia's leading property investment adviser and one of Australia's 50 most influential Thought Leaders. His opinions are regularly featured in the media.