Interest-only or principal and interest: how home loan repayments work

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Kooky

Builder of Shaka, the payment router that pays every agent their commission on closing date.

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Every home loan answers one plain question each month: how much of the payment goes to the bank's interest, and how much goes to the debt itself. On a principal and interest loan, each repayment does both. On an interest-only loan, for a set number of years, the repayment covers the interest alone and the amount owed does not move.

The choice looks small on the application form. It is not small over the life of the loan. An interest-only period lowers the early repayments, but the debt is then repaid over fewer years, so the later repayments are higher than they would have been from the start. Federal regulators have written about this repayment jump for more than a decade, and the rules lenders follow when they approve an interest-only loan are built around it.

This guide sets out how each type of repayment is calculated, what happens on the day an interest-only period ends, how the prudential regulator and the credit regulator expect lenders to assess these loans, and why the answer differs for someone living in the home and someone renting it out. A worked example, computed line by line, runs through the whole guide. Its interest rate is an assumption chosen to make the arithmetic clear, not a rate any lender offers.

Illustrative figures: a $600,000 loan over 30 years at an assumed 6.00% a year, with a five-year interest-only period. Not a market rate.

Two ways to repay the same debt

A home loan has two parts. The principal is the amount borrowed. Interest is what the lender charges for the use of that money, worked out on the balance still owing. Moneysmart, the consumer site run by the Australian Securities and Investments Commission (ASIC), defines an interest-only loan as one where the repayments only cover interest on the amount borrowed.

On a principal and interest loan, the repayment is set so that the debt reaches zero at the end of the agreed term, such as 25 or 30 years. In the first years, most of each payment is interest, because the balance is at its highest. As the balance falls, the interest share shrinks and more of the same payment goes to the principal. The repayment itself stays the same while the rate stays the same.

On an interest-only loan, the borrower pays only the interest for an agreed period. Moneysmart's page on these loans uses a five-year period as its example and explains that, during it, nothing is paid off the amount borrowed, so the balance stays where it started. When the period ends, the loan switches to principal and interest for the rest of the term, and the repayments rise.

The prudential regulator's guidance for banks gives a sense of how long these periods run. The Australian Prudential Regulation Authority (APRA), in its practice guide on residential mortgage lending, known as APG 223, describes the interest-only term as usually one to five years, although it may extend longer. A box in the Reserve Bank of Australia's Financial Stability Review of April 2017 described the period as typically the first five to ten years of a loan.

How each repayment is calculated

The interest-only repayment is simple arithmetic. The yearly rate is divided by twelve and applied to the balance. On a $600,000 loan at an assumed 6.00% a year, the monthly rate is 0.5%, and the interest each month is $3,000. Because the balance never falls, the repayment stays at $3,000 every month for the whole interest-only period, as long as the rate does not change.

The principal and interest repayment uses the standard amortisation formula, which finds the single monthly amount that pays all the interest as it falls due and clears the balance exactly at the end of the term. On the same $600,000 at 6.00% over 30 years, that amount is $3,597.30 a month. In the first month, $3,000 of it is interest and $597.30 reduces the debt. By the last years of the loan, the proportions are reversed.

The two repayments in the example differ by $597.30 a month. That gap is the whole appeal of an interest-only period: lower outgoings now. It is also the amount that is not being paid off the debt each month, which is why the balance at the end of five years is so different between the two loans.

After five years of principal and interest repayments, the balance in the example has fallen from $600,000 to $558,326, so $41,674 of the debt has been repaid. Over the same five years, the interest-only borrower has paid $180,000 in total, all of it interest, and still owes $600,000. The principal and interest borrower has paid $215,838, of which $174,164 was interest.

The worked example, side by side

The table below follows the same loan down both paths. Every figure comes from one script run on the assumptions stated in its source line. The rate is held at 6.00% throughout, which a real loan is unlikely to do over 30 years; the point is to isolate the effect of the repayment type.

Two results stand out. The first is that the interest-only borrower ends up paying more each month from year six than the principal and interest borrower ever pays: $3,865.81 against $3,597.30. The reason is time. The full $600,000 now has to be cleared in 25 years instead of 30.

The second is the cost. Over the full term, the interest-only path costs $44,713 more in interest, about 6.4% more than the principal and interest path, because the balance stayed higher for longer and interest was charged on it. The Reserve Bank's 2017 box made the same point with its own example: a $400,000 loan at 4% with a five-year interest-only period cost about 9% more in interest over the term than a comparable principal and interest loan. The two percentages differ because the loans, rates and terms differ; the direction is the same.

The day the interest-only period ends

The repayment jump is the moment the whole arrangement has been building towards. In the example, the monthly repayment moves from $3,000 to $3,865.81 overnight, a rise of $865.81 a month, or 28.9%. Nothing about the loan has changed except the repayment basis.

The Reserve Bank's 2017 box put the typical rise at about 60% for its example loan, a much larger figure. The gap with the example in this guide comes mainly from the interest rate. At a lower rate, interest makes up a smaller part of the principal and interest repayment, so moving from interest alone to a full repayment is a bigger proportional step. Moneysmart's own illustration, a $500,000 loan over 25 years with a five-year interest-only period, shows repayments of about $2,010 a month rising to $3,250 when the period ends.

The rate itself can add to the jump. An interest-only period of five years is long enough for the cash rate to move several times. If the rate in the example were 7.00% instead of 6.00% when the switch happens, the principal and interest repayment over the remaining 25 years would be $4,240.68 a month. Moneysmart warns borrowers of exactly this: repayments rise at the end of the period, and rise further if interest rates have gone up.

A longer interest-only period makes the later step steeper still. If the example loan had ten years of interest-only repayments, the remaining 20 years at 6.00% would need $4,298.59 a month. Each extra year without principal repayments shortens the time left to repay the whole debt.

Planning for the switch

Moneysmart's guidance for borrowers approaching the end of an interest-only period comes down to a few practical moves, set out in order below. None of them is a prediction about any individual loan; each depends on the loan's terms and the borrower's situation.

The first step has a simple logic. Moneysmart's own example is a borrower whose repayments will rise by $1,200 a month in a year, who starts paying an extra $100 a month now. In the worked example in this guide, the rise is $865.81 a month; paying some of that early both reduces the balance before the switch and tests whether the higher figure fits the household budget.

Some borrowers ask for the interest-only period to be extended rather than switching. That is a new credit decision for the lender, not an automatic option, as the next section explains. Borrowers who expect the higher repayment to be beyond them face a different question, financial hardship, which this magazine covers in its own guide.

How lenders assess an interest-only loan

Two regulators shape the assessment. APRA supervises banks and other authorised deposit-taking institutions for safety and soundness. ASIC enforces the responsible lending obligations of the national credit law, which apply to every licensed lender and broker, including those in Queensland.

APRA's guide, APG 223, is direct about the repayment period. For interest-only loans, it expects lenders to assess whether the borrower can meet future repayments on a principal and interest basis over the specific term in which those repayments apply, excluding the interest-only period. Put simply, the bank does not test the borrower against the lower interest-only repayment. It tests the borrower against the higher repayment that comes later, calculated over the shorter remaining term.

The same guide sets the serviceability buffer: lenders must apply a buffer of at least 3.0 per cent over the loan's interest rate, unless APRA determines otherwise. Applied to the worked example, an assessment at 9.00% (the assumed 6.00% plus 3.0) over the 25 years left after a five-year interest-only period gives $5,035.18 a month. The same assessment over a full 30 years would give $4,827.74. That difference of about $207 a month is why the remaining-term rule matters: it makes an interest-only loan slightly harder to qualify for than the same loan repaid from day one.

This was not always the practice. In August 2015, ASIC published a review of interest-only lending by 11 lenders, including the four major banks, based on more than 140 loan files. In about 40% of the files, the affordability calculation assumed the borrower had longer to repay the principal than the loan actually allowed. In more than 30%, there was no evidence that the lender had considered whether an interest-only loan met the borrower's requirements. ASIC reported that all 11 lenders had changed their practices or committed to doing so. APRA wrote to bank boards in April 2018 asking them to confirm that interest-only loans were assessed on the principal and interest period alone.

The responsible lending side

ASIC's Regulatory Guide 209, issued in December 2019, explains how lenders and brokers meet the responsible lending obligations. Among them, it says a lender should make inquiries that allow it to understand the consumer's requirements and objectives, and then assess whether the product offered meets them.

For an interest-only loan, that means the reason for the interest-only period is part of the file. ASIC's October 2015 consumer release, which followed its review, said lenders and brokers must make sure interest-only loans match their customers' requirements and objectives and are consistent with the customer's plans. The same release advised borrowers to check that they could afford the higher repayments at the end of the period, allowing for a possible rate rise, and to keep a margin above the minimum repayment.

In practice, a borrower asking for an interest-only period can expect to be asked why, and the answer is weighed against the borrower's plans and finances. Whether a given reason supports the loan is a judgement each lender makes on the full application.

Owner-occupiers and investors

APRA's guide treats the two groups differently. It accepts that borrowers may have legitimate reasons to prefer interest-only loans, such as repayment flexibility or tax reasons, and also notes that these loans may carry higher credit risk in some cases and may not suit every borrower.

For owner-occupiers, APG 223 sets a higher bar. APRA expects a lender to approve an interest-only loan for someone living in the home only where there is a sound and documented economic basis for it, and not because the borrower cannot service the loan on a principal and interest basis. It also expects interest-only periods to be of limited duration, particularly for owner-occupiers.

For investors, the logic is often tied to tax. Moneysmart notes that investors may be able to claim higher tax deductions on an investment property with an interest-only loan, because the interest on the investment loan stays higher for longer. How interest deductions work on a given loan depends on what the money was used for and on the investor's own tax position; that is a question for the Australian Taxation Office's rules and for a registered tax agent, not for a repayment calculation.

The historical figures show how lopsided the two groups once were. The Reserve Bank's 2017 box reported that interest-only loans made up about 23% of owner-occupier lending and about 64% of investor lending at that time. Those shares come from before the regulatory changes described in the next section, and should not be read as today's figures.

How the rules on interest-only lending changed

Interest-only lending was the target of specific regulatory limits in the second half of the 2010s. The Reserve Bank's 2017 box records that APRA and ASIC took measures on interest-only lending practices in late 2014, and that on 31 March 2017 APRA announced that banks should limit new interest-only lending to 30% of total new residential mortgage lending, with tight management of interest-only loans at high loan-to-valuation ratios.

The 30% limit was always meant to be temporary. On 19 December 2018, APRA announced that it would remove the benchmark, saying that the share of new interest-only lending had fallen well below 30%. Banks that had already been released from the earlier investor lending benchmark were released from the interest-only benchmark from 1 January 2019. APRA said it still expected banks to keep adequate oversight of the level and type of their interest-only lending, to follow APG 223, and to meet ASIC's responsible lending obligations.

The same period brought a pricing change. The Reserve Bank's 2017 box reported that the four major banks had announced average interest rate premiums on interest-only loans of 18 basis points for owner-occupiers and 15 basis points for investors. Moneysmart's current guidance still says the interest rate on an interest-only loan may be higher than on a principal and interest loan. Any premium is set by each lender and can change; the 2017 figures describe that year only.

Extending or switching mid-loan

A borrower partway through a loan may want to change its repayment basis, in either direction. Moving from interest-only to principal and interest early means paying more each month, and how a lender processes that request depends on its own loan terms.

Moving the other way is a different matter. APRA's guide expects a lender to carry out a new serviceability assessment whenever there are material changes to a loan, and it names two of them: a change of repayment basis from principal and interest to interest-only, and the extension of an existing interest-only period. In both cases, the lender reassesses the borrower as it would a new application, including the remaining-term test and the buffer described above.

APG 223 also recognises a different use of interest-only periods. In its section on hardship and collections, it lists longer periods of interest-only lending among the concessions a lender may offer a borrower in difficulty. That is a separate path, tied to the borrower's difficulty rather than to a fresh application.

What the numbers mean for a borrower

The worked example shows the trade in its simplest form. Five years of interest-only repayments save $597.30 a month against a principal and interest loan at the same rate. In exchange, the borrower faces a repayment $865.81 higher when the period ends, owes $41,674 more at that point than a principal and interest borrower would, and pays $44,713 more in interest over 30 years if nothing else changes.

An interest-only period does not make a loan cheaper. It moves the repayment of the debt into fewer, later years, and charges interest on the balance while it waits.

Whether that trade makes sense depends on the purpose. For an owner-occupier, APRA expects a documented economic reason and a limited period. For an investor, the tax treatment may change the arithmetic, and that depends on the investor's own position. For both, the lender will test the higher repayment, not the lower one, and the borrower can make the same test at home before signing: take the repayment that applies after the switch, add a margin for higher rates, and check that it fits.

The figures in this guide are illustrative. A real loan has fees, a rate that moves, and terms that vary between lenders. The structure, though, is the same on every interest-only loan: a period where the balance stands still, then a shorter road to zero.

Kooky, from Shaka

Kooky edits Queensland Estate and builds Shaka, the payment router he made for Queensland property professionals. One payment comes in, and every agent, agency and party in the deal receives their signed share on closing date.

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