Principal & Interest vs Interest-Only (IO) Loans: Which Is Better for You?

Investment Loans

8 Oct

Choosing between principal and interest and interest-only loan repayments is one of the biggest decisions you’ll make when taking out a home loan. Both repayment types have pros and cons depending on your goals, cashflow and whether the loan is for your home or an investment property. Below I explain the difference in plain language, the situations where each option usually makes sense and the practical risks to watch for.

What they are

Principal and interest repayments pay down both the loan balance and the interest each month. Over the life of the loan the balance reduces and you eventually own the property outright. Interest-only repayments cover only the interest charged for a set term - usually 1 to 5 years - and the loan balance stays the same while the interest-only period applies. After that term you must either switch to principal and interest or refinance.

When principal and interest suits you

If you want to pay your loan off faster and build equity, principal and interest is usually the better option. The regular repayment structure reduces your loan balance which lowers long-term interest costs. It also gives more certainty for budgeting because you are steadily reducing debt rather than facing a large jump in repayments later. This is the default choice for most owner-occupiers and those focused on debt reduction.

When interest-only can make sense

Interest-only is commonly used by investors who prioritise cashflow and tax planning because interest on an investment loan is generally tax-deductible in Australia. It can also help owner-occupiers through short-term cashflow pressure, for example during renovations or a temporary income dip. That said, interest-only is typically a short-term strategy and best used with a clear plan for what happens when the interest-only term ends.

What lenders and regulators expect

Lenders must assess your capacity to repay under the National Credit framework and ASIC guidance, so an interest-only request will be scrutinised to ensure it is appropriate for your situation. Lenders are also sensitive to the broader rate environment and funding costs, which affect how competitively they price interest-only versus principal and interest options. Recent central bank and bank funding updates show movements in funding costs and lending practices that can change how attractive certain loan options are. That means product features and rates can shift over time.

Risks and practical points to check

Repayment shock: Once the interest-only period ends your repayments often jump because you must start repaying principal as well. Make sure you can afford that higher repayment.
Interest rate sensitivity: If rates rise, interest-only repayments will increase and you do not reduce the loan balance, so you remain more exposed to rate rises. Recent market moves and lender responses have changed available rates for different loan types.
Equity and refinancing: Because the balance does not fall during an interest-only period you build equity slower. That can affect your options to refinance later or access further borrowing. Monitor lending indicators and market trends to understand how lenders are treating investors versus owner-occupiers.

Practical examples

You are buying your first home and want to minimise long-term interest paid and own your home sooner: principal and interest is usually the safer choice.
You are an investor with a strategy that depends on maximising cashflow in the first few years and you have a tax plan that benefits from deductible interest: interest-only for a limited term may be appropriate, provided you have an exit plan.
You face a temporary income drop or have short-term work that reduces available cash: interest-only can help, but only if you are confident you can switch back to principal and interest later.

How to decide for your situation

Think about whether your priority is lowering the loan balance or improving short-term cashflow. Factor in your risk tolerance for rate rises, how long you plan to hold the property and whether you have a clear plan for the end of an interest-only term. Ask for repayment illustrations that show the repayment “shock” after an interest-only period and compare total interest costs over different scenarios.

Conclusion

There is no universal answer to whether principal and interest or interest-only is better. Principal and interest gives long-term certainty and equity growth. Interest-only can improve short-term cashflow and fit some investor strategies but carries more risk if the plan for the end of the interest-only term is weak. Weigh your goals, cashflow, tax position and how long you plan to hold the loan, and compare real repayment examples to see which path suits you.