Interest Only or Interest and Principal, What Is the Difference?

Thursday, November 26, 2015 / Property Finance, Property Investment

Generally speaking, when someone purchases a home that they intend on living in, they get a mortgage which is then paid off over a set period of time. Each week they pay the interest on the loan amount, and then they pay off a portion of the debt itself.

The portion which is paid off of the debt is called the ‘principal’.

As time goes on, and more and more principal has been paid, the amount of interest that is paid each week diminishes, whilst the amount of principal that is paid each week increases.

For example, if you were to take out an owner occupied mortgage of $400,000 at an interest rate of 4.82% per annum, and were making payments of interest and principal the weekly cost would be $525.87, this would be the same amount every week for the term of the loan.

In the first month of the loan you would pay $1606.67 in interest, and then pay $496.67 off of the total amount owed.

If we fast track by ten years we can see that the monthly ratio changes to $1299.75 in interest for the month, with a payment of $803.75 coming off of the total amount owed.

This compounds further and further as time goes on. At about the 15 year mark (or half way through the loan term) we finally see more principal being paid than interest each week.

This graph shows the ratio of interest vs principal that is made up of each payment over the 30 year loan term:

 

 

As you can see, towards the end of the loan term there is more and more principal being paid off and less interest being paid. However, in the beginning there is considerably more interest being paid than principal.

Using an Interest Only Loan for Investment Purposes

An investment loan is significantly different to your initial home loan; and quite often will come in the form of an interest only loan.

This loan structure forgoes the portion of the payment that would otherwise be paying off the principal.

This means that every week when the payment is made, it is paying only the interest portion of the loan and never actually reducing the total amount that is owed.

For example, if you were to take out an investment loan, at 4.82% per annum, for $400,000; your weekly payment would be $401.66. After ten years of making these payments, you would still have weekly payments of $401.66 (providing that there is no interest rate change), yet the total loan amount would still be $400,000

Why would an investor opt for this loan structure?

The goal of the investment property in this situation is not to have it paid off and remain a permanent asset. The goal is to simply hold the property long enough for the property to increase in value, with the intention of selling it off at a certain point.

Over a ten year period, the $400,000 loan would have incurred $192,800 in interest payments (these payments are offset by rental income from the property), however the value of the property will have also increased over this time.

The wealth from the property in this situation is created by selling the property for a higher amount than the loan value, costs of maintaining the property, and the interest costs of the period it was held for.

If like many Australian properties, this example property had doubled in value over the ten year period, then the investor stands to sell it for $800,000 and then pay off the $400,000 that they owe on the loan, as well as easily covering the $192,800 that they have made in interest payments. This is without even taking into account the additional income provided by renting out the property or the additional tax savings that stand to be made; this also does not cover the maintenance and upkeep costs of the property. 

The most important thing to do is assess these options against your personal investment strategy

When it comes to investing there is never a clear and present easy option for every situation. Decisions such as whether to opt for an interest only loan or to opt into paying off principal at the same time, is not a decision that should be rushed.

We highly recommend that you take he time to discuss your investment strategy with a professional investment strategist; and to also discuss your investment lending with a well experienced investment mortgage broker.