Mortgage principal and interest loans: pay off your loan faster

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Home loans with repayment of principal and interest are the most common type of mortgage in Australia. Principal is simply the money you borrow. You pay that back, with interest charged by the lender on top of that. With principal and interest repayments, you pay off part of the loan amount and interest at the same time. This means that you are reducing your overall debt with every repayment.

The less common alternative to principal and interest loans are interest-only loans. These have higher rates and cost more in the long run, but have lower repayments up front. They are popular with real estate investors and borrowers who wish to temporarily reduce their repayments.

Compare home loans with principal and interest in the table below

When you borrow money to buy a house, you have to pay it back – obviously. The amount of money you borrow is called the loan principal (sometimes referred to as the loan amount). You have to pay this money back over time, but you also have to pay interest.

Interest is a sum of money that is added to the principal of the loan. The amount of interest you pay is determined by the interest rate on your home loan. The principal amount of your loan also affects the amount of interest charged. The more you borrow, the more interest you pay.

How do principal and interest mortgage loans work?

Most home loans are principal and interest loans. With these loans, you pay off the loan principal plus interest at the same time. Every month, you make repayments on your home loan. Part of the repayment is interest and part of principal.

Here is a simple example using Finder mortgage loan repayment calculator:

  • Property value. You buy a house for $ 600,000.
  • Deposit. $ 120,000.
  • Principal of the loan. $ 480,000.
  • Interest rate. 2.60%.
  • Term of the loan. 30 years.
  • Monthly repayments (principal and interest). $ 1,921.

With this example, you are paying back $ 1,921 per month (assuming interest rates don’t change). With the additional interest charged, your loan principal of $ 480,000 plus interest will end up costing you $ 691,787 over 30 years.

That’s $ 211,787 in interest charges plus the original loan principal.

Why am I paying more interest and less principal at the start of the loan?

When you start paying off a mortgage, you may notice that the bulk of your repayment is to pay off the interest at the start of the loan. Only a small amount will go towards the principal. As you continue to pay off the loan, you will pay off more principal and less interest.

This is because your lender has calculated exactly how much you will need to spend on each repayment in order to repay your loan within the term you have agreed. The result of these calculations is called the amortization plan. The schedule shows how much of your payments is allocated to interest and how much is allocated to principal. The amount that goes to pay off the principal increases over the years and does so at a faster rate.

Here’s a simple graph to illustrate how mortgage interest and principal are paid back together over time.

Principal and Interest Loans Versus Interest Only Loans

Borrowers have an alternative to repaying principal and interest: interest free mortgage. These loans have an initial period during which the borrower does not repay the loan principal at all. Instead, they only pay the interest charges.

This makes their repayments smaller at the start. But eventually the loan will revert to the repayment of the principal and the interest, which means that you will have to repay the principal.

This means that interest-only home loans start out cheaper but end up being more expensive.

Here is an example using two loans. They are the same except one is principal and interest while the other is interest only for the first three years.

Principal of the loan $ 400,000 $ 400,000
term of the loan 30 years 30 years
Interest rate 2.45% 2.45%
Interest period only N / A 3 years
Monthly repayments $ 1,570 $ 817 (during the interest period only)
$ 1,689 (after the interest period only)
Total interest $ 165,237 $ 176,574
Total cost of the loan over 30 years $ 565,237 $ 576,574

Here we can see that making interest payments only for 3 years is ultimately costing you $ 11,337 in additional interest.

Why do some borrowers choose interest-only payments?

Interest-only loans are commonly used by investors to minimize their non-tax deductible costs (interest charges on an investment property). are tax deductible but principal payments are not).

This can be advantageous for investors who plan to hold investment property for a short time in a growing market. Instead of paying off the loan, these investors anticipate rapid capital growth (the property’s value increases) and then sell the property. With this strategy, an interest-only loan allows the investor to minimize his repayments.

Some homeowners choose to only pay interest for a short period of time if they are having trouble repaying or if they have reduced income.

Capital and interest calculator

You can use Finder’s free home loan calculator to see how principal and interest on a home loan works.

Just enter a few basic details about the loan, including the loan amount (the principal) and an interest rate. In the Repayment type field, you can select P&I (principal and interest) or interest only.

How do you compare principal and interest mortgages?

When you compare loans with principal and interest payments, the interest rate is the first thing to consider. The lower the interest rate, the lower your repayments will be.

But there is more to it:

  • Interest rate. The lower the better, but watch out for the fine print. Some home loans offer fairly low introductory discount rates but later revert to a higher rate.
  • Type of rate. You need to look at fixed and variable rate loans and decide which one is best for you. Variable rates tend to offer more functionality and greater flexibility, while fixed rates offer certainty in repayments. Learn more about the fixed versus variable decision.
  • Characteristics. Compare the characteristics of the loan and make sure that the loan offers what you need (for example, a Compensation account, portability or the ability to make additional refunds).
  • Purpose of the loan. Make sure you are comparing the right type of loan for your particular situation. If you are an investor, consider both principal and interest investment loans. If you are buying a home, you will need to look at homeowner loans for principal and interest.
  • Costs. The interest rate is not the only thing that affects your costs. Review the fees that come with the loan, including application fees, settlement fees, and ongoing charges.
  • Lender. Remember to compare lenders. You might want the speed and convenience of an online lender, or you might want to talk to a loan specialist at one of the big banks. Different lenders have different risk appetites depending on your borrowing circumstances, so it’s worth checking with a few lenders before submitting a full application.

How can I repay the principal of my loan faster?

A big advantage of both principal and interest home loans is that you pay off the loan principal from day one. This means you don’t just pay debt, you build equity in your home (it’s the value of your property minus any outstanding debts).

And if you can pay off the loan faster, you’ll pay off your debt sooner and pay less interest. There are several ways to do this, and it depends on the characteristics of your loan:

  • Make additional refunds. If your loan allows you to make additional refundsso you can repay the loan faster. Even paying $ 100 more per week on your mortgage could save you thousands of dollars in interest over the life of your loan.
  • Use your matching account. Better yet than additional repayments, if your loan has an offsetting account, you can put extra money in it. This mimics the effect of additional repayments by reducing your loan principal, but if you need to access the money, it’s up to you (but if you do take it out of the clearing account, the principal of your loan will increase).
  • Make bi-monthly repayments. Switch from monthly to bi-monthly repayments gives you a slight boost. Indeed, there are 12 months in the year but there are 26 fortnights, which effectively gives you about fifteen additional reimbursements per year.
  • If your rate goes up, change. If you’ve had your home loan for a few years, you might be surprised at your current rate. Yes, rates are low right now, but your lender may only be offering their best deals to new customers. Ask your lender for a lower rate or switch to a better mortgage with a new lender, can save you thousands of dollars. If you get a lower interest rate but your repayments stay the same as before, you are actually making additional repayments immediately.

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