A principal and interest loan pays down the debt as you go. An interest-only loan does not. For a set period, usually up to five years, your repayments cover the interest and nothing else, so the balance at the end is the balance you started with. That one difference drives almost everything else.

How principal and interest works

Each repayment covers the interest charged for the period and also knocks something off the loan itself. Early on most of the payment is interest. Over time the split shifts, and more of each payment goes to the debt. It is the default for owner-occupiers, and for good reason: the loan has a clear end date.

How interest-only works

During the interest-only period, the repayment is lower because you are not reducing the debt. When the period ends, the loan switches to principal and interest, and here is the part people underestimate. The remaining term is now shorter, so the debt has to be repaid over fewer years. The new repayment is higher than a standard loan of the same size would have been.

Who uses interest-only, and why

  • Investors. Interest on an investment loan is generally tax-deductible, while paying down principal is not, so some investors prefer to keep the loan balance steady and put spare cash elsewhere. Whether that makes sense for you is a conversation for your accountant.
  • People with a short-term cash flow squeeze. A renovation, a career break or a new baby can make a lower repayment useful for a while.
  • Buyers holding two properties. If you are buying before you sell, interest-only on one loan can ease the overlap. We cover that in our guide to bridging finance.

What you give up

  • You build no equity from repayments. Any growth in the property's value helps you, but your payments are not reducing the debt.
  • You pay more interest overall. The balance stays higher for longer, so more interest is charged over the life of the loan.
  • Pricing can differ. Lenders often price interest-only loans differently from principal and interest loans, and policy on how much they will lend varies between lenders.
  • The payment jump. When the period ends, repayments rise. Lenders assess you on that higher figure up front, which can reduce how much you can borrow. Our piece on how much you can borrow explains the assessment.

What happens when the interest-only period ends

You usually have three options. Let the loan roll onto principal and interest at the higher repayment, ask the lender for a new interest-only term, or refinance. Extending is not guaranteed. Lenders reassess your income and circumstances, and some will not extend at all, especially for owner-occupied loans. Put the end date in your diary when you sign, and start the conversation well before it arrives.

Can you mix the two?

Often, yes. Some borrowers split the loan, keeping part on interest-only and part on principal and interest. Others stay on principal and interest but hold money in an offset account, which gives similar flexibility with the debt still being paid down. Our guide to offset accounts vs redraw covers how that works.

Which one suits you?

For most owner-occupiers, principal and interest is the sensible default. For investors, interest-only can make sense when it fits a wider plan, but it is worth stress-testing against the repayment you will face when it ends. The right answer depends on your income, goals and the loans on offer, and those differ a lot between lenders. If you would like to talk it through, get in touch or call 1300 001 755. We are licensed credit advisers in Forestville, working with clients across the Northern Beaches and North Shore.

Frequently asked questions

What is the difference between interest-only and principal and interest?

With principal and interest you repay the debt as well as the interest, so the balance falls. With interest-only you pay just the interest for a set period, so the balance stays the same.

How long can a home loan be interest-only?

Commonly up to five years, though the limit varies between lenders and between investment and owner-occupied loans.

What happens at the end of the interest-only period?

The loan normally switches to principal and interest, usually with a higher repayment because the debt is repaid over a shorter remaining term. You may be able to ask for a new interest-only term or refinance.

Is interest-only a good idea for an investment property?

It suits some investors, because interest is generally tax-deductible and cash flow is higher during the period. It carries risks, including no equity from repayments. Check with your accountant and a broker.

General information only. It does not take your objectives, financial situation or needs into account, and it is not credit or financial advice. Lender policy, rates and eligibility change regularly and vary between lenders — talk to us about your own circumstances before acting on anything here.