Knowing how principal and interest factor into a home loan will give you a fuller picture of the mortgage process and aid in your decision-making.
How does principal and interest work on a home loan?
Most mortgages in Australia, such as standard variable interest rate loans, require you to simultaneously pay off both a principal and an interest amount — as well as the fees attached to the loan.
- Principal is the amount of money you borrow from your lender.
- Interest is the price your lender charges you for borrowing the money.
- The interest rate is calculated as an annualised percentage of the principal.
Principal and interest home loans differ from interest-only home loans, in which payments are only applied toward the interest amount for a limited time.
How repayments work
The interest rate is one of the critical indicators of the length of your loan and the total repayment figure.
With a standard variable interest rate loan, you pay off the principal with interest simultaneously. That means every time you make a mortgage repayment, a portion goes to both.
For example, say you have a $400,000 home loan with a 20-year term and a 4% interest rate. You would repay almost $30,000 during the first year of homeownership, with nearly $16,000 going to interest. That means only $14,000 will be taken off the principal (the amount outstanding on your mortgage).
How to calculate repayments
The term of your mortgage, which has a maximum of 30 years in Australia but can be as short as 10, is calculated as the amount of time it takes to pay off the principal of the mortgage using a minimum required amount, paid either fortnightly or monthly, with the rate agreed on with your lender.
However, the interest rate fluctuates throughout the mortgage. If interest rates go up, that does not mean the mortgage term will be extended. You’ll have to make larger payments to meet the principal and interest requirements of the mortgage.
As a stark example of what can happen during rising interest rates, let’s say you borrowed $500,000 over a 20-year term.
With the current standard variable rate of 6.18%, your monthly repayments are $3,634. But if rates jump to 7.8% in a year, your repayments will increase to $4,120 a month, which is nearly $500 more. This is the reason why many Australian home buyers struggle to make repayments when rates are high.
Conversely, if rates go down, your repayments will decrease. If, in this example, you were to continue to put that extra $500 a month toward your mortgage principal when rates are low, you would pay the loan off much sooner.
How do interest-only home loans work?
An interest-only loan is unique in that you are only required to pay the interest on your mortgage, not the principal, for an agreed-upon period — up to a maximum of five years in Australia. After the interest-only period expires, the mortgage reverts to a principal and interest loan.
Interest-only home loan repayments are lower during the initial period because you’re not truly paying off any of the principal. This means your outstanding balance remains the same. It also means that when the interest-only period finishes, your repayments will increase dramatically.
Principal and interest vs interest-only loans
Interest-only loans are initially cheaper than principal and interest mortgages. You could conceivably use the money you save during this time to pay off other debts or invest it elsewhere for a better return, in the short term at least. For owners of investment properties, interest-only home loans also come with taxation benefits.
However, principal and interest home loans tend to have lower repayments over the life of the loan since minimum repayment chips away at the total principal.
The rate for an interest-only loan is likely to be higher than on a principal and interest loan. That means you’ll end up paying more over the mortgage term.
Additionally, with an interest-only loan, you may pay nothing toward the principal for quite some time. In this scenario, you only build equity and wealth if the property increases in value. At the same time, you could easily find yourself underwater if the value falls and your circumstances change for the worse.