Principal and interest versus interest-only repayments: what changes

Choosing between principal and interest (P&I) and interest-only (IO) repayments is not a choice about whether you pay interest. You pay interest either way. The choice is about when you start reducing the amount you borrowed, and what that does to your repayments now, your repayments later, and the total interest charged across the life of the loan.

This guide explains the mechanism so you can weigh the trade-off against your own numbers, then tells you what to confirm with your lender before you commit.

What each repayment actually covers

MoneySmart, ASIC's consumer website, describes the difference directly: with an interest-only loan, "your repayments only cover interest on the amount borrowed". Principal is the amount you borrowed; interest is the cost of borrowing it.

• Principal and interest (P&I): each repayment covers the interest charged for that period plus a slice of the principal. The balance falls every repayment.
• Interest-only (IO): each repayment covers the interest charged for that period and nothing else. The balance stays where it started, unless you voluntarily pay extra.

That single difference drives everything else in this article.

	Principal and interest	Interest-only
What the repayment covers	Interest plus part of the borrowed amount	Interest only
Loan balance during the period	Falls each repayment	Stays at the starting amount
Repayment size at the start	Higher	Lower
What happens later	Repayments stay broadly level (subject to rate changes)	Repayments step up when the interest-only period ends

What changes to the loan balance

Interest on a home loan is charged on the outstanding balance. If the balance does not fall, the interest charged each period does not fall either.

With P&I, part of every repayment permanently reduces the balance, so the base that interest is calculated on shrinks over time. Late in a P&I loan, most of the repayment is principal and very little is interest.

With IO, the balance is unchanged across the interest-only period. You have not gone backwards, but you have not made progress either. When the interest-only period ends, you still owe the original amount, and you now have less time left on the loan to repay it.

This is the trade-off in one sentence: interest-only lowers your repayment today by moving the principal reduction into a shorter window later.

What changes to total interest

Because interest is calculated on the outstanding balance, a loan that stays at its full amount for longer attracts interest on that full amount for longer. Over a like-for-like loan term, that generally means more interest in total than a P&I loan of the same size, rate and term.

Treat that as a mechanism, not a prediction. The actual difference depends on the loan amount, the interest rate, the length of the interest-only period, whether you make extra repayments during it, and the remaining term once it ends. Two borrowers with the same loan can end up in very different places depending on what they do with the cash-flow difference.

If you choose interest-only and spend the entire saving, you absorb the full cost of the higher balance. If you choose interest-only and direct the saving into an offset account while keeping your total payment at the P&I level, you can end up paying down the loan faster than a standard P&I loan — because offset balances reduce the interest charged. Whether offset is available, and how it works, is a product feature you need to confirm.

What changes when the interest-only period ends

MoneySmart states plainly: "At the end of the interest-only period, the loan will change to a 'principal and interest' loan." This is automatic, not optional.

That change has two consequences worth planning for:

1. Your required repayment rises. You move from covering interest only to covering interest plus principal.
2. The principal is repaid over a shorter remaining term. MoneySmart's worked example uses a five-year interest-only period; the shorter the original term, the larger the step-up at the end, because the same principal has to be cleared in fewer years.

So the relevant question is not "can I afford the interest-only repayment?" It is "can I afford the repayment that starts when this period ends?" Model that number before you sign, not after.

Why some borrowers still consider it

Interest-only is not automatically the wrong answer. It is a cash-flow tool, and cash flow matters in specific situations.

Borrowers commonly look at it when income is temporarily lower, when a renovation or build means the property is not generating income yet, or when they want payment flexibility and intend to use an offset account or make voluntary extra repayments.

MoneySmart's own example makes the point that the answer depends on the person. In it, a borrower weighs an interest-only period of five years against a principal and interest loan, and "decides that a principal and interest loan, with constant repayments of $2,875, will work better for him." Stability of repayment, not just size, was part of the decision.

Note what that example does not do: it does not say interest-only is worse in every case. It shows a borrower running his own numbers and choosing based on his situation. That is the method, not the verdict.

Questions to confirm before you choose

Product rules differ by lender, and the details are where the cost is. Ask your lender, in writing:

• How long is the interest-only period, and is it fixed at approval or renewable?
• What exactly will my repayment be on the day the period ends?
• What is the remaining loan term at that point?
• Can I make extra repayments or use an offset account during the interest-only period, and are there conditions or fees?
• Is the interest rate on the interest-only portion the same as on a comparable P&I loan from the same lender?
• Are there different fees, features or eligibility criteria attached to the interest-only option?
• What happens if I want to switch to P&I early?

Get the end-of-period repayment figure as a number. A lender comparison that only shows today's repayment is showing you half the picture.

How to run your own comparison

MoneySmart points readers to its interest-only mortgage calculator, which works out repayments "before and after the interest-only period". Use a calculator that shows both, and run three scenarios:

1. P&I from day one — note the repayment and the total interest over the full term.
2. Interest-only, then P&I — note the lower repayment now, the higher repayment later, and the total interest.
3. Interest-only, with the difference saved in offset — if offset is available, see whether that closes the gap on total interest while keeping the flexibility.

The output you care about is not the monthly difference. It is the difference in total interest and the size of the future step-up.

Next steps

• Get the specific numbers for your loan amount, term and rate, including the end-of-period repayment.
• Check whether your loan allows offset or extra repayments during the interest-only period.
• If you are buying as an investment, confirm the tax treatment of interest with the ATO or a registered tax agent, as it depends on the purpose of the loan and your circumstances.
• Revisit the choice when your circumstances change. The option that suits a year of lower income may not suit the following decade.

If you want to see how different home loan structures compare on features and repayments, you can browse current home loan options at /money/home-loans/. If you would rather be matched to lenders based on your situation, start with /match/.

General information only

This article is general information about how home loan repayment structures work. It is not personalised legal, tax, credit or financial advice, and it does not take account of your objectives, financial situation or needs. Interest rates, fees, loan features and eligibility criteria change and differ between lenders. Check current details with the lender and the product's terms and conditions, and consider speaking to a licensed mortgage broker or financial adviser before making a decision.