Knowing how principal and interest factor into the way a home loan functions will give you a fuller picture of the entire mortgage process and aid in your decision-making process when you start the great homeowner quest.
What is principal and interest on a home loan?
The principal is the amount of money you borrow from your lender, while the interest is the price your lender charges you for the privilege of borrowing the money. The interest rate is calculated as an annualised percentage of the principal.
Most mortgages in Australia, such as standard variable interest rate loans, require you to simultaneously pay off a principal amount and an interest amount, as well as the fees attached to the loan.
Principal and interest home loans are different from interest-only home loans, in which payments are only applied toward the interest amount, for a limited period of time.
How principal and interest repayment works
With a standard variable interest rate loan, unlike an interest-only loan, you are paying off the principal with interest at the same time, so every time you make a repayment a portion goes to both.
For example, with a 4% interest rate on a $400,000 home loan, you will pay $16,000 a year in interest.
So if you make total repayments of $30,000 in your first year of homeownership, you will only have taken $14,000 (after the interest is deducted) off the principal, or the amount outstanding, on your mortgage.
The interest rate is one of the key indicators of the length of your loan and the total repayment figure.
How to calculate principal and interest payments
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 interest rate agreed on with your lender.
However, the interest rate fluctuates over the course of the mortgage. If interest rates go up that does not mean the term of the mortgage will be extended, you’ll just have to make larger payments to meet the principal and interest requirements of the mortgage.
As a stark example of what can happen in a time of rising interest rates, let’s say you borrowed $500,000 over a 20-year term.
With the current standard variable rate of 4.82%, your monthly repayments are $3,250. But if rates jump to 6.49% in a year’s time, your repayments will increase to $3,725 a month, which is nearly $500 more. This is the reason why many Australian homebuyers 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 charges on your mortgage, not the principle, for an agreed-upon period — up to a maximum of five years in Australia. After the interest-only period expires, the mortgage reverts back to a principal and interest loan.
The payments on an interest-only home loan are lower during the initial period but because you’re not actually 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 interest rate for an interest-only loan is likely to be higher than on a principal and interest loan, which means you’ll end up paying more over the term of the mortgage.
Additionally, with an interest-only loan, you may pay nothing toward the principal for quite some time. In this scenario, you are only building wealth if the property increases in value, while you could easily find yourself underwater if the value falls and your circumstances change for the worse.
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