Principal and Interest versus Interest only.
October 2, 2013 12:14 AM   Subscribe

Please confirm or otherwise guide me about the distinction between a principal and interest versus an interest only home loan, in the important context of 100% offset.

OK, so you are not my financial advisor and your response does not purport to be financial advice (this is the boilerplate in Australia for people who aren’t allowed to give financial advice).

If I want to take out a $300 000 mortgage, which will be 100% offset by any cash I choose to leave in the account, then I can choose principal and interest, or interest only. Using this useful calculator, if I go P&I, 25 years, then monthly payments are $1910, and the total repayments are $575k, of which interest is $275k.

If I choose IO, (but only ten years at a go since that is all they will offer you), the monthly repayment is $1410 and you’ve paid $176k in interest at ten years, and you’re of course left with the principal to pay off at ten years. But I will have saved the $500 pcm (and growing) difference for those ten years, so will have about $75 000 in the account offsetting the loan (this is slowly compounding , the more I save the less I pay), so would owe maybe $225k (I wish I had a better calculator that would work this out). I take out another IO loan at this time, monthly repayments start at $1100 pcm, saving $800 a month (compared to P&I), this difference grows to more than $1200 a month by year 20, I’d owe about $100 000 when that loan ended, and need to pay maybe another $125k in the next five years to discharge the loan fully.

So, considering flexibility and total payments, IO seems to be a better deal in the long run?
posted by wilful to Work & Money (7 answers total)
I like these little purchase conundrums.
It looks the $1410 is the monthly repayment over 25 years on your calculator for a total payment of $741K.
posted by Kerasia at 1:03 AM on October 2, 2013

The reason that people borrow money to finance a home purchase is that they do not have the money to pay cash, or they wish to use the cash they have for some other purpose.

Over time, with a standard mortgage, they build up equity. That process is very slow over the first years, and accelerates over the last years.

An interest-only loan builds no equity. You are calculating a way to pay for the land (build your equity) in chunks, at ten year intervals, using the cash that you have built up by saving on the payments.

This can make sense if you are certain that you will have the means to pay off the loan at the end of each 10-year period, or if you are certain that the bank will reoffer the same terms at that time. Many people do not have that level of certainty. Given recent history, you cannot even be certain that the bank will be around in ten years.
posted by yclipse at 1:54 AM on October 2, 2013 [2 favorites]

Best answer: I'm guessing OP's in Australia or New Zealand based on the terminology. Things work a bit differently over here. The OP is indeed planning to build equity - just holding it in an offset account rather than the main loan account.

OP, if you're planning to put the same total payment (loan payment + offset payment) then P&I or IO makes no difference to the total interest you'll pay or the total payments. Only the split between loan account & offset account changes.

That said, there are some considerations for IO as follows:
The money in your offset can be withdrawn and used for another property or purpose, without affecting the deductibility of the original loan interest. So you might want to go IO to maximise the amount you can keep in offset for this purpose.

The IO is for a limited term (e.g. 10 years). Then you have to reapply and if your circumstances have changed, or the economy has changed, the bank might decline to roll you over to a new term. Then you're stuck with finding another lender. A P&I loan is for the whole 25-30 year term, at the negotiated rate, so you don't face that rollover risk.
posted by dave99 at 2:01 AM on October 2, 2013 [1 favorite]

My tuppence: when interest rates are low, pay off the principal and the interest. Chuck as much money as you can safely do to reduce the principal. Interest rates will rise if and when economies heat up or overheat. This should be true even for an offset. When you pay off the principal and the interest you are basically front loading your commitments in terms of paying off the loan.

When you choose interest only you do so because you either don't want to commit the extra cash right now to paying off the principal and/or because you have a better use for your cash and/or because you have the means to pay off lump sums in due course.
posted by MuffinMan at 2:59 AM on October 2, 2013

The principal and interest method and the interest only method are equivalent only if the interest rates on the loan and the savings account are equal. Generally the savings interest rate is lower so you are losing money by saving rather than paying principal. The savings interest is even less if you have to pay income tax on it.

The amount you are losing each month is the difference between the monthly loan and savings interest rates (after tax) times the total amount accumulated in the savings account that month. In other words, the longer you go and the more you have in your savings account, the faster you lose.
posted by JackFlash at 10:10 AM on October 2, 2013

I don't have an answer for you, but just to make your calculation more complicated: do remember that if you go IO, and accumulate the difference in some interest-bearing arrangement, that interest is taxable, while the benefit you get from having money in the offset account is not.
posted by pompomtom at 5:55 PM on October 2, 2013

Response by poster: yclipse, that wasn't the question I asked. And given the banks have all been around 100 years or more, and are all highly profitable, I don't think that's any concern.

JackFlash, in an offset account, effectively the money you have is saving you interest payments, so it's effectively the same interest rate as the mortgage rate.
posted by wilful at 6:43 PM on October 2, 2013

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