In light of the interest rate hikes and falling house prices, many have been looking into choosing between interest-only (IO) and principal and interest (P&I) repayments, which represent the two main options for loans.

Borrowers should make an informed decision and adopt a good loan reduction strategy that suits their needs by understanding their goals and financial capacity.

P&I is the most common loan repayment type, with a defined term the loan will be repaid in, which is usually 30 years. P&I loans help ensure your home loan will be paid out in a specified repayment term by making the minimum repayments each fortnight/month.

Under a P&I loan, your equity may grow faster as your loan is being paid down each month and historically studies have shown that Australian property has increased in value over time.

You start paying off the principal balance of your loan right from the start. Therefore, borrowers potentially pay less interest over the life of the loan when compared to an interest-only loan. On the same note, P&I loans generally have lower interest rates as well.

The interest-only home loan is generally a more popular option with investors as it only repays the interest of the loan amount owing for a set period of time. Usually, an interest-only loan will be set on a term between one to five years.

Once this period ends, it will be rolled over to a P&I loan structure where the original loan and interest will be repaid, this is generally repaid over the remaining term.

For example, if you took a 30-year term originally and your IO period was five years, you will now need to repay your full loan over 25 years instead of 30. This could mean your new P&I repayments will be higher than if repaid over the original 30-year term.

An IO loan generally means lower monthly repayments for an agreed period. Investors take advantage of this window to repay their owner-occupied loan down quicker while owning an investment property.

It is especially beneficial for investors to get into the market as soon as possible to extract as much equity as possible in the future. However, while the overall monthly repayment may be lowered when not paying off the principal, investors need to pay attention to the higher interest rate charged.

Many homeowners and investors look at offset accounts. An offset account is beneficial as it allows for additional savings to be kept outside of the loan and still “offset” the amount owing and therefore reducing your interest accrued.

The offset loan could also offer additional benefits like a linked debit card and a visual way to see your savings vs redraw/additional repayments in your loan.

When choosing between the options, there are clear benefits to both – be sure to properly assess your situation and seek financial advice to make a better decision.

Source: Money Magazine