A principal and interest loan repays the amount borrowed and the lender's interest charge with each scheduled repayment. Interest-only lowers the initial payment by postponing principal repayment, but leaves a higher repayment when that period ends.
Choose principal and interest when the aim is to reduce debt steadily. Use interest-only for a defined cash-flow need only when the later repayment is affordable. The smaller first payment does not show the full cost of the loan.
How Principal and Interest Work Together
Principal is the amount you owe. Interest is the lender's charge on that balance, usually calculated daily and charged monthly. A principal and interest repayment pays the accrued interest and reduces the debt.
Early repayments contain more interest because the balance is higher. As the balance falls, less interest accrues and more of each repayment goes towards principal. The amortisation schedule shows how each repayment splits over the term.
A shorter term raises the repayment but reduces total interest. For a hypothetical $600,000 loan at a constant 6%, a 25-year term costs about $3,866 a month. Extending repayment to 30 years reduces the monthly amount to about $3,597 but adds roughly $135,287 in interest. These estimates use monthly calculations and exclude fees, extra repayments and offset savings.
Principal and Interest Versus Interest-Only
Principal and interest (P&I) repayments reduce the balance from the start. Interest-only repayments cover interest for an agreed period, so the balance stays unchanged unless you make extra repayments.
| Feature | Principal and Interest | Interest-Only Period |
|---|---|---|
| Minimum repayment | Interest plus principal | Interest, with fees payable separately or under the loan terms |
| Loan balance | Falls with scheduled repayments | Stays unchanged without extra repayments |
| Rate | Often lower for the same borrower and product | Often higher than P&I |
| Later repayments | Calculated to clear the debt over the term | Recalculated to clear the balance over the shorter remaining term |
When an interest-only period ends, the full balance must be repaid over the years left. Five interest-only years on a 30-year loan leave 25 years for principal repayment. The step-up can occur even if the rate stays unchanged.
Lenders set both individual-period and lifetime limits. CommBank's interest-only limits allow five years at a time, with lifetime totals of five years for owner-occupiers and 15 for investors. Westpac's published limits are five years for owner-occupiers and up to 15 for investors, subject to approval.
Investors still receive a limited interest-only period within the loan term. Some products also impose a lower maximum loan-to-value ratio (LVR) for interest-only borrowing. That means a larger deposit or more equity can be needed.
The lower initial repayment rarely increases borrowing capacity. Under APRA's APG 223 Residential Mortgage Lending, banks assess future P&I repayments over the remaining term, excluding the interest-only period. They also apply a serviceability buffer of at least three percentage points above the loan rate, with a lender floor where applicable.
Build the exit into the original recommendation. Model the post-period repayment and a higher-rate case before settlement. Where the loan has an offset account, save the repayment difference there to reduce interest and prepare for conversion. Diarise a review 12 months before expiry so an extension or refinance is an option to assess, rather than the only way to afford the loan.
The Long-Run Cost Difference
Interest-only costs more in total interest when you compare the same loan balance, positive rate and total term without extra repayments or offset savings. The debt stays higher for longer. A higher interest-only rate adds to that cost.
In the hypothetical $600,000 example, five years of interest-only at 6% costs $3,000 a month. P&I over the remaining 25 years then costs about $3,866 a month. Total interest is about $739,743, compared with $695,029 for P&I across the full 30 years. The interest-only option adds about $44,713 before any rate premium or fees.
Interest-only can still suit an investor preserving cash flow or a borrower managing parental leave or a business ramp-up. The temporary benefit needs a documented conversion plan and enough income to meet the later repayment. Tax treatment depends on the use of borrowed funds and the borrower's circumstances, so refer that question to an accountant.
Choosing a Structure for a Client
Choose P&I when reducing debt within the agreed term is the priority and the repayment fits the budget. Interest-only needs a specific temporary cash-flow reason and an affordable exit. Work through four questions with the client.
- What is the property purpose? Record whether it is a home or investment, and refer tax questions to an accountant.
- How tight is the budget now, and how reliable is the income expected after the interest-only period?
- When does the client expect to sell or repay the loan, and what happens if that timing changes?
- How will the client manage the interest-only exit if the lender declines an extension or refinance?
Record how the choice meets the client's goals and the cost they accept. Before applying, review the client's credit score, deposit and existing debts. Correct credit-file errors and reduce costly debts where affordable. Compare both structures using the lender's assessment rate and remaining-term rules.
If the goal is to reduce the balance sooner, compare ways to pay off a mortgage faster. When access to extra repayments matters, explain the lender's redraw rules before the client pays money into the loan.
Where Deposit Size Triggers Insurance
A deposit below 20% of the property value commonly triggers lenders mortgage insurance (LMI). LMI protects the lender if the borrower defaults and the sale proceeds do not cover the debt. Eligible schemes and lender waivers can change whether it applies.
For brokers, compare LMI premiums and eligibility across the lenders and insurers available through your aggregator. The client generally cannot select an insurer independently of the lender. Include any capitalised premium in the loan balance and repayment model because the borrower pays interest on that added debt.
Reviewing and Restructuring Later
An annual review identifies approaching interest-only expiries and fixed-rate loans moving to a revert rate. It also checks whether equity growth supports better pricing or a lower LVR. Keep the separate 12-month pre-expiry reminder for an interest-only loan.
Before refinancing, compare the savings with break costs and application fees. Model the remaining term as well as any proposed longer term. A lower monthly payment from restarting the term can still increase total interest.
Refer tax treatment to an accountant and broader financial planning to an appropriately qualified adviser. For a client who cannot meet the conversion repayment, discuss the position with the lender before expiry. A financial counsellor can help with an unaffordable household budget.
A Check Worth Running Before You Recommend
Run an amortisation comparison for the proposed loan at both P&I and interest-only before recommending a structure. Use the actual balance, product rates and fees. Include the repayment after interest-only ends, total interest and the remaining debt at the client's expected sale or repayment point.
Repeat the comparison at a higher rate and test the later payment against the client's budget. Save both schedules with the recommendation and record how the client will fund the step-up. Choose the structure whose full repayment path the client can afford.
