What is the difference between Principle vs Interest Only Home Loans?

When it comes to Home Loans, if you are like me then all the terms that are thrown around can make you feel very overwhelmed and perhaps even make you feel a little stupid…

But not to worry! This simple break down will at least help you keep pace with what your chosen institution is talking about.

A little trivia – did you know that the word “Mortgage” derives from Old French and loosely translates as “An Agreement until Death”. Not exactly my idea of fun…. and that’s why it is vitally important to understand what you are getting into.

First we must establish and understand what the term “Principle” actually is? Principle is the total amount you need to borrow to acquire a particular item. In this case it will be the house or land (property). It’s worth noting though that in the case of a small or personal loan it could be the total of the car or holiday amount required.

For these purposes we will assume that you have fallen in love with your first home and to purchase you will need $386,520 including closing cost and all taxes. This figure is the Principle amount.

So now let us break each loan down:

Principal Home Loans

Commonly referred to as the “Principle & Interest” loan, it is the basic and stock standard loan right across all institutions.

If we take that original figure of $386,520 (principle) that was needed to purchase your first home the lending institution will charge an “Interest” component on top of the principle amount as percentage. This is a way of not only making money but think of it as; a way that a business can justify giving you the right to spend their money.

When you make a mortgage payment whether fortnightly, monthly etc. you are paying off both principle and interest at the same time.

With the interest rates you have a couple options available; fixed rate homes loans, or variable – some split the loan in halves and use both options. Each option has its pros and cons which really isn’t for me to tell you which you should go for (as it’ll be up to your own personal circumstances). Let’s break down the options a little further:

  • Fixed Rate Loans – As the name suggests you lock in for a pre-determined period at the rate that is available at the time of offer. The usual terms available are 1, 2, 3 and 5 years. The fixed term rate is 99% of the time cheaper than the variable rate. However this is depending on the current economic climate and conditions.
  • Variable Rate Loans – Are completely opposite of the above fixed rate, these rates are not locked in and fluctuate with current economic cycles and events. This rate is attractive when the economy is not doing so well, and in-turn ideal for paying down that principle debt quicker.

Interest Only Home Loans

By choosing this option, every time you make a mortgage payment the whole amount will only be made towards the interest component. With none of the payment amount made paying down the principle. This will continue until your chosen period has finished and the loan will automatically default to Variable.

The main benefit of this loan is if cash flow is tight; you will always know what your repayments will be. The repayments will also be lower than Variable; the following is an example using our $386,520 principle figure:

Principle & Interest Home Loans

Loan Amount                     $386,520
Term of Loan                     30 Years
Interest Rate                     5.25%
Repayment Frequency   Weekly
Weekly Payments            $492

Interest Only Home Loans

Loan Amount                    $386,520
Term of Loan                     30 Years
Interest Rate                     5.25%
Repayment Frequency   Weekly
Weekly Payments            $389

Difference = $103 a week more in your pocket using the interest only option.
**Using online home loan repayment calculator www.mozo.com.au/home-loans/resources/calculators/mortgage-repayments-calculator

It’s really important to note that whilst the repayment difference can be significant (as with the above example), the downside is the principle amount will be exactly the same as when you started.

It truly is crucial to get the right advice and have the right conversations when looking at what options best suit your needs.

I hope this breaks the whole process down and makes it a little easier when making the decision and talking to your lending institution.

 

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