Traditional vs. Interest-Only Loans

In recent years, interest only loans have popped up as an option for home loans. For first time home buyers, are they the right option? Understanding the difference between traditional principle and interest loans (P&I) and interest only loans can help you make a better decision when you take out a mortgage for your first home.

The Basics

With a traditional Principal and Interest (P&I) loan, each monthly payment would go towards paying interest as well as paying off the principle. Each month you will be reducing the loan amount. However, monthly payments during the interest-only period would purely go towards paying interest to your lender on an interest only loan.

This means that the payments can be much lower, but you will not truly be paying off the debt of the loan during the interest-only period.

Traditional Loans

For most home buyers traditional loans are generally the most attractive option. Most potential home owners want to own their home as soon as possible, with the lowest monthly payments. A traditional P&I loan gives homeowners the best return on their investment as part of each monthly payment goes towards paying off the principle.

Since the principle is the actual loan being taken out, a principal and interest loan lets buyers reduce their debt and build equity most effectively

Interest Only Loans

Interest only loans will have a fixed period, usually 5 years, during which the payments go purely towards paying interest and not reducing the principal. The benefit is that monthly payments can be significantly lower than that for traditional P&I loans.

However, at the end of 5 years, the homeowner will still essentially owe the same amount to the lender. That doesn’t sound great, but there are actually good reasons to choose an interest-only loan.

Investors

Interest only loans make a lot of sense for Australians looking to buy property as an investment. Interest only loans have lower monthly payments, which for property investors frees cash to be invested in other areas. For tax purposes, the interest portion of monthly mortgage repayments can be deducted from taxes but the principle portion cannot, so they can be quite an attractive way to finance investment properties. This is known as negative gearing and is a major reason to choose interest-only loans for investors.

Homeowners

For homeowners the situation is more complicated. The main danger with interest only loans is that a homeowner only sees the low monthly interest payment figure and ends up buying a home bigger and more expensive than they can really afford.

They end up making significant interest payments over time without reducing principal and make very little progress towards really owning their home. Another risk is that the property value decreases during the interest-only term.

However, smart homeowners who purchase a home within their means can still make good use of a interest-only home loan. An interest-only loan means lower mandatory monthly payments, but you can often still make extra repayments to pay off principal, just like a P&I loan. In this regards, interest only loans are more flexible than traditional loans, while ensuring monthly payments are affordable.

Choosing the type of mortgage is a key decision for home buyers whether they will own and live in the house or use it purely for investment purposes. Those who understand the pros and cons of interest only loans can stand to benefit, but those who try to use interest only loans to buy houses they can’t afford will end up in trouble.

To find more about P&I loans, interest only home loans, and get other financing advice for your first home, contact First Home Owners Centre’s friendly finance team today.