Principal & Interest vs. Interest-Only Loans: Which is Right for You?

Video Transcript

Robbie:

Hey, something else that you need to be really informed about is the differences between principal and interest loans or interest only loans. Really important that you understand the differences between slugging away your mortgage or just paying the minimum, putting a structure in place to allow that property to go up in value. So here’s our trustee property, $650,000 property with a $450,000 loan.

Let’s just say for argument sake, your principal and interest component on that repayment is $2,500 a month. The principal component is $500 and the interest component is about $2,000 a month. Now, as you can see, you basically pay that on and you are now effectively paying down your mortgage or salami slicing your mortgage off away you go.

You are saving your way to wealth and effectively in 30 years time, you would have paid off your own home, which is amazing. So that’s how a principal and interest repayment works. Let me change tack for a second.

Who’s also heard of the term rent money’s dead money? You can see on the screen there, right? Oh, I just want to buy my own home. Rent money’s dead money. Oh, got it.

No dramas. But here’s the thing. Interest on your principal and interest loan is also dead money.

Or you can look at it the other way. It’s the dance with the devil that you need to do because the bank has lent you that money and they’re always going to place a premium on it. They’re not going to lend you that money for free.

You need to be able to pay that back with interest. So we want to be able to try and attack the amount of interest that you pay as much as we possibly can. Now over time, as you pay more and more principal off your loan, the ratio between the principal and the interest will change in your favour.

You can see now that we’re not 500 to 2000, we’re 600 to 1900. A period of time down the track, you might be 800 to 1700 and effectively you can see that you pay your loan off quicker towards the end of the period as opposed to, you know, it’s quite flat at the top there. There’s another little video you’re about to watch shortly that effectively explains how paying off your home loan in the first few years versus the last few years, there’s a massive difference.

I know some of you would have also heard the fact of like, what if I pay a hundred bucks extra per month or per fortnight off my home loan? I’m like, yeah, that’s a bloody great idea. It can wipe many years off your loan and you can see there you effectively bring the time that takes to pay the loan off a much quicker. But what you’re also doing there is you’re bringing redraw funds into your loan.

Redraw is actually another, it’s a technical jargon term as well, whereby because you paid extra on your loan, depending on the bank and the circumstances around how you got your loan and the products and features of that loan, you can sometimes access some of your redraw. I put it in red there because you can effectively use that as your emergency cash buffer. So that’s the difference between paying principal and interest and interest only.

Here’s that little slide that I just spoke about. So where do you think your principal and interest loan repayment goes? You can see this is a very generic illustration. In years one to five, effectively you’re paying almost 90% interest and only 10% principal.

A lot of people like, yeah, got to go on principal and interest straight away. Got to start paying that home down. I’m like, good on you champ.

That’s awesome. But please be aware you’re not salami slicing that loan off very fast, like not as much as what you think anyway. So you can see really conventional home loan repayments have you mostly pay interest in the first six to 10 years.

You can see even after year 10, it’s still very much in favour there. About halfway through the loan, it gets to a point where you’re paying 50-50. And then as I sort of said, the back end of the loan, whereby you’re paying only a very small amount of interest.

And then perhaps in the last five years, because you’ve already paid all the interest back, the bank’s like, right, that two and a half grand a month can just go now to just completely wiping off your home loan in the last five years. Generically, if you’re doing that with an investment property, you’ll see the tenant pays about 70% of the loan. The tax man still pays a good portion of it.

But of course, then you’ve got to top up the rest of it. So in that instance, the property will be negatively geared and negative cashflow because you’re now paying an extra 7, 8, 9,000 bucks a year off the principal to cope with it. If you’re doing an interest only loan though, whereby you’re just paying the bare minimum to effectively put a structure in place to allow that property to go up in value, your first and last instalment generally over a one, two, three, four or five year period will be exactly the same.

And you can see from a cashflow point of view, it works in your favour so much better, whereby the tax man and the tenant effectively take care of the mortgage for you. You don’t have to put any extra in because you’re not paying the principal component. That’s the differences between principal and interest or interest only loans.

They’re really great tools and you should use them interchangeably at different times during the portfolio status and the growth period that you’ve got.