Quick answer
On a principal and interest loan, each repayment covers interest and reduces the amount you owe. On an interest-only loan, you pay only the interest for an agreed period, so the balance does not fall. Interest-only keeps early repayments lower but usually costs more overall, and repayments rise when the loan reverts to principal and interest.
Key points
- Principal and interest repayments reduce the loan balance over time.
- Interest-only repayments cover interest alone, so no equity is built through repayments.
- Moneysmart warns that repayments rise when the interest-only period ends, so plan for the higher amount.
- Short-term private loans are often interest-only by design, with a clear plan to repay the full amount.
What does principal and interest actually mean?
Every loan has two parts. The principal is the amount you borrowed. The interest is what the lender charges for letting you use it. On a principal and interest loan, each repayment pays the interest that has built up and then puts the rest towards the principal. Early on, more of the payment goes to interest. Over time the balance falls, interest shrinks and more of each payment reduces the debt.
It is the standard structure for most home loans and many business and asset loans. The appeal is straightforward: if you keep up the repayments, the loan ends at zero.
What is an interest-only loan?
Moneysmart describes it this way: on an interest-only loan, repayments cover only the interest on the amount borrowed, and the principal stays the same during the interest-only period. You build no equity through repayments. When the period ends, the loan generally switches to principal and interest, and repayments rise.
The interest-only period is set at the start. Moneysmart gives five years as an example but does not treat that as a rule, so lengths vary by lender and product. Some short-term loans are interest-only for their entire life, with the whole balance due at the end.
How do the two compare?
| Feature | Principal and interest | Interest-only |
|---|---|---|
| Repayment covers | Interest plus part of the debt | Interest only |
| Balance over time | Falls | Stays the same |
| Early repayments | Higher | Lower |
| Total cost over the term | Usually lower | Usually higher |
| Equity from repayments | Builds gradually | None |
| After the interest-only period | Not applicable | Reverts to principal and interest, with higher repayments |
| Typical use | Owner-occupiers and long-term borrowers | Investors, short-term plans, cash-flow management |
No structure is automatically better. The right one depends on what you are trying to achieve and how you plan to repay the debt.
When might interest-only make sense?
Interest-only can fit a plan when there is a clear way to repay the principal later, or when lower early repayments solve a short-term problem. Examples include:
- Investors who prefer to keep cash flow free, often with a long-term strategy discussed with their accountant.
- Short-term finance such as bridging, where the loan is repaid from a sale or refinance. Our guide on bridging loan exit strategies covers that.
- Renovations or developments where income arrives after the work finishes.
- Temporary cash-flow pressure where lower repayments buy time.
- Private mortgages that are designed to be short, with a defined exit. See our page on interest-only private loans.
What these have in common is a plan. Interest-only without a plan can leave you owing the same amount years later.
What are the risks?
Moneysmart highlights a few, and they are worth reading closely:
- Repayments rise when the interest-only period ends, because the debt is repaid over a shorter remaining term.
- No equity from repayments. If property values do not rise, you may end up with little or no equity, which leaves you exposed to a downturn or a forced sale.
- Rising costs. If your rate is variable, repayments can climb further.
- A higher overall cost than principal and interest.
Moneysmart suggests calculating repayments before and after the interest-only period, increasing repayments gradually if the loan allows it, and speaking to your lender early if you cannot afford the new amount. Free financial counselling is available if you are struggling.
How do lenders assess interest-only loans?
Under responsible lending rules, a lender must make reasonable inquiries about your situation and check the loan is not unsuitable. Many lenders assess interest-only applications on the basis of the higher repayments that will follow once the interest-only period ends, which can reduce how much you can borrow. Policies differ, which is one reason a broker’s comparison matters. Our guide to loan serviceability goes deeper.
For investment lending, see our page on investment property loans, and for home buyers specifically, interest-only home loans explains the structure further.
What about private and short-term loans?
Private lenders often favour interest-only because the loan is short and the plan is to repay the full balance from a sale, refinance or other event. In some cases the interest can be paid up front or added to the loan, which is a different mechanism covered in our guide to capitalised interest. A short-term mortgage or bridging finance arrangement will normally spell out the term and exit in the contract.
The key question is always the same: how will the full amount be repaid when the term ends?
An illustrative example
This is an illustrative scenario only.
An investor and a young family each borrow the same amount. The family chooses principal and interest, so every repayment shrinks the debt, and in time they own more of the home. The investor chooses interest-only for a set period to keep cash flow free while renovating and then selling part of the holding. Their balance stays the same during the period, and they plan to repay from the sale proceeds.
Both can be sensible choices. The risk for the investor is that the sale does not go as planned, so a backup plan matters. The risk for the family is smaller, but their repayments are higher from day one.
What mistakes should I avoid?
- Choosing interest-only only because the repayment looks smaller.
- Forgetting that repayments jump when the period ends.
- Having no exit plan for a short-term interest-only loan.
- Assuming you can always extend. Extensions usually need a new assessment.
- Ignoring the overall cost.
- Not telling your accountant, since tax treatment depends on the use of the loan.
How does Ownright help?
We start with your goal and work back to the structure. Trevor Scott has spent more than 40 years in finance and knows when interest-only helps and when it is a trap. We can look at principal and interest, interest-only or a mix, and arrange lenders Australia-wide who will consider the structure that fits. To test a structure against your own plans, begin with a quick enquiry.
Ready to pick the right repayment structure?
Sounds like you are looking for a loan with the right repayment structure for your plans. We are the lending experts in interest-only and principal and interest finance, from home loans to short-term private lending, so click the button and see if you qualify.
Frequently asked questions
What is the main difference between the two?
With principal and interest, part of every repayment reduces the debt, so the balance falls over the term. With interest-only, repayments cover just the interest charged, so the debt stays the same. Interest-only can lower early repayments, but it does not reduce what you owe unless you pay extra.
Is interest-only cheaper?
Repayments during the interest-only period are lower, but the loan is often more expensive overall. Moneysmart notes that because the principal is not reduced, interest accrues on the full amount for longer, and the rate on an interest-only loan can be higher. The answer depends on the loan, the term and your plans.
What happens when the interest-only period ends?
The loan normally switches to principal and interest over the remaining term, which means higher repayments because the same debt must now be repaid over fewer years. Moneysmart advises working out the new repayments in advance and checking you can afford them.
Who uses interest-only loans?
Common users include investors, people managing short-term cash flow, borrowers with a planned sale or refinance, and those on short-term private loans where the lender expects the full balance to be repaid at the end. It is a tool, not a default, and suits some plans better than others.
Can I switch between the two?
Often yes, but it depends on the lender and your loan terms. Switching to principal and interest is usually straightforward, while extending an interest-only period typically requires a fresh assessment. Ask your lender or broker about conditions and any fees before you decide.