Interest Only vs Principal and Interest Home Loans: Which Is Better?

How Principal and Interest Loans Work

A principal and interest loan splits each monthly repayment into two parts: one portion covers the interest charged on the outstanding balance, and the other reduces the loan principal itself. This structure means your loan balance decreases with every repayment, and you gradually build equity in your property over the life of the loan. In the early years, the majority of each repayment goes towards interest, with only a small amount reducing the principal. As the loan balance decreases, more of each repayment is applied to the principal, accelerating the rate at which you pay off the loan. This is known as amortisation.

For example, a $600,000 loan at 6% over 30 years has a monthly repayment of approximately $3,597. In the first month, around $3,000 goes to interest and $597 reduces the principal. After five years of repayments, the remaining loan balance is approximately $555,000, meaning you have paid off $45,000 in principal and built that amount in equity (plus any property value growth).

P&I loans are the standard loan structure in Australia and are the default option offered by most lenders for owner-occupied home loans. They ensure that your debt is fully repaid by the end of the loan term, typically 25 or 30 years.

How Interest Only Loans Work

An interest only loan requires you to pay only the interest charged on the loan each month, with no reduction to the loan balance during the interest only period. This means your repayments are lower during the IO period, but your debt stays exactly the same. You are essentially renting money from the lender without paying any of it back.

For example, a $600,000 loan at 6% on interest only has a monthly repayment of $3,000. After five years of IO repayments, the loan balance is still $600,000. You have paid $180,000 in interest over those five years and built zero equity through repayments (though property value growth may have increased your equity position).

Interest only periods are typically available for 1 to 5 years, after which the loan automatically reverts to principal and interest repayments for the remaining term. Some lenders allow you to extend the IO period, subject to approval, but APRA guidelines and responsible lending requirements mean extensions are not guaranteed. The maximum total IO period across the life of a loan is usually 10 years for investors and 5 years for owner-occupiers.

Side by Side Comparison

The key difference is simple: P&I builds equity and costs less in total interest, while IO preserves cash flow in the short term but costs significantly more over the life of the loan.

The total interest cost difference is substantial. On a $600,000 loan at 6% over 30 years, choosing IO for the first 5 years costs approximately $65,000 more in total interest compared to P&I from day one. This is because the loan balance does not reduce during the IO period, so you pay interest on a higher balance for the remaining 25 years when the loan converts to P&I.

Who Should Choose Interest Only?

Interest only loans are primarily suited to property investors who want to maximise their tax-deductible interest, preserve cash flow, or hold a property for a shorter period before selling. There are several situations where IO can make financial sense:

• Investors maximising deductions: Because the full IO repayment is interest, 100% of the repayment is tax deductible for investment properties. With P&I, only the interest portion is deductible, and the principal component is not.
• Short-term holders: If you plan to hold a property for 3 to 5 years and sell, IO keeps your holding costs low during that period. Paying down principal on a property you plan to sell soon provides limited benefit.
• Cash flow management: IO frees up cash that can be directed to paying down non-deductible debt (such as your own home loan) faster, or invested elsewhere for a higher return.
• Expecting income growth: Borrowers who are early in their career and expect significant income increases may choose IO now and switch to P&I when they can comfortably afford higher repayments.

Who Should Choose Principal and Interest?

Principal and interest is the right choice for most owner-occupiers and any borrower whose primary goal is to pay off their home loan and build equity over time. P&I suits the following situations:

• Owner-occupiers: Interest on your own home loan is not tax deductible, so there is no tax benefit to keeping the balance high. Paying P&I reduces your debt and builds equity in your home.
• Long-term holders: If you plan to live in or hold a property for 10 years or more, P&I ensures your debt steadily decreases, reducing your total interest cost and increasing your financial security.
• Equity builders: P&I builds equity with every repayment, which can be used later to fund renovations, invest in additional properties, or provide a financial safety net.
• Risk-averse borrowers: P&I provides certainty that your loan will be fully repaid by the end of the term, with no repayment shock when an IO period expires.

Most financial advisers and mortgage brokers recommend P&I for owner-occupiers. The slightly higher monthly repayment compared to IO is the cost of building genuine equity and reducing your overall debt. Over a 30-year loan term, the difference in total interest paid between P&I and IO (with a 5-year IO period) can be $50,000 to $80,000 or more.

The IO Cliff: What Happens When Interest Only Expires

When your interest only period expires, your repayments jump because you now need to repay the full loan balance over the remaining term, which is shorter than the original loan term. This repayment shock catches many borrowers off guard and is one of the biggest risks of choosing IO.

Here is a concrete example. You have a $600,000 loan at 6% with a 5-year interest only period on a 30-year term. During the IO period, your monthly repayment is $3,000. When the IO period expires after 5 years, the loan reverts to P&I for the remaining 25 years. Your new monthly repayment is approximately $3,862. That is an increase of $862 per month, or $10,344 per year.

If you had chosen a 10-year IO period on the same loan, the remaining P&I term would be just 20 years. The monthly repayment would jump to approximately $4,298, an increase of $1,298 per month compared to the IO repayment.

You have several options if you cannot afford the increased repayments when the IO period expires:

• Extend the IO period: Some lenders allow IO extensions, subject to approval and assessment. This is not guaranteed and depends on your financial position and the lender's policies.
• Refinance to a new IO term: Moving to a new lender with a fresh IO period. This involves new application costs and assessment, and the new lender will assess your ability to eventually repay the loan at P&I rates.
• Switch to P&I early: Transitioning to P&I before the IO period expires allows you to spread the adjustment over a longer period and build equity sooner.
• Sell the property: If the repayment increase is unmanageable, selling the property may be the most practical option, particularly if the property has increased in value.

Interest Rates: IO vs P&I

Interest only rates are typically 0.20% to 0.60% higher than principal and interest rates, meaning you pay more per dollar borrowed in addition to not reducing your balance. Lenders charge a premium for IO loans because they carry more risk: the loan balance does not decrease, and borrowers who choose IO may be more stretched financially.

The rate premium means that an investor choosing IO is typically paying the highest rate of any borrower type. On a $600,000 loan, a 0.50% rate premium adds $3,000 per year in additional interest cost. This should be factored into any comparison between IO and P&I, as the lower IO repayment is partly offset by the higher interest rate being charged.

Can You Switch Between IO and P&I?

Yes, most lenders allow you to switch between interest only and principal and interest during the life of your loan, though switching to IO typically requires lender approval and a fresh assessment of your financial position.

Switching from IO to P&I is straightforward. Most lenders allow this as a simple product change, often with no fees. Since you are choosing to pay more and reduce your debt faster, lenders are generally happy to accommodate this change. It can usually be done online or over the phone.

Switching from P&I to IO is more involved. The lender will typically require a new serviceability assessment to confirm you can afford the repayments when the IO period eventually expires. This may include providing updated income documentation. Some lenders charge a fee for this product change, and approval is not guaranteed, particularly if your financial circumstances have changed or if APRA's lending guidelines have tightened.

Refinancing to a new lender is always an option if your current lender does not offer the product change you want. A mortgage broker can compare options across multiple lenders to find the best rate and terms for your situation, whether you are looking for IO or P&I.