How to determine the right type of home loan for you

Principal and interest vs interest only

Principal and interest

With a principal and interest loan, your repayments cover both the loan amount (principal) and the interest. This means that with each repayment, you're gradually reducing the total amount you owe, while also paying the interest on the outstanding balance. Over time, this approach lowers the loan balance and builds equity in the property, with the loan being repaid in full by the end of the loan term.

Pros:

• Builds equity: Your loan balance decreases with each payment.
• Lower interest paid overall: Paying down the principal means you’ll pay less interest over the life of the loan.

Cons:

• Higher repayments: Since you’re repaying both principal and interest, monthly payments are higher than interest-only loans.

Interest only 

An interest-only loan, your repayments cover only the interest for a set period (typically 1-5 years), after which you start repaying both principal and interest.  During this time, the loan balance (principal) remains unchanged, and you don’t build equity in the property. Once the interest-only period ends, you are required to start repaying both the principal and interest, often resulting in significantly higher repayments, unless you extend your interest-only period. Interest-only loans are popular with investors who want to minimise their outgoings in the short term, but they generally cost more in interest over the life of the loan.

Pros:

• Lower repayments: During the interest-only period, your payments are lower.
• Increased cash flow: This can be useful for investors or those wanting to manage short-term expenses.

Cons:

• No equity built: You don’t reduce the loan principal during the interest-only period.
• Higher overall cost: Once the interest-only period ends, repayments increase significantly, and you’ll pay more interest over the loan’s life.

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Fixed vs variable interest rates

Fixed interest rate

A fixed interest rate offers a stable interest rate for a set period, typically between one and five years. After the set period has ended, your loan will revert to a variable rate unless you extend your fixed rate period.

Pros:

• Predictable repayments: Your repayments remain the same for the fixed term, providing certainty.
• Protection against rate hikes: If interest rates rise, your rate and repayments stay the same.

Cons:

• Limited flexibility: If interest rates fall, you won’t benefit from lower repayments.
• Break fees: Exiting the loan early can incur significant break costs.

Variable interest rate

A variable interest rate offers a fluctuating interest rate based on market conditions.

Pros:

• Potentially lower rates: If interest rates drop, your repayments decrease.
• Greater flexibility: Many variable loans offer features like offset accounts and redraw facilities.

Cons:

• Unpredictable repayments: Your monthly payments may increase if interest rates rise.
• Budgeting challenges: It can be harder to predict and manage long-term expenses.

Split loan (combination of fixed and variable):

A split loan combines both fixed and variable interest rate portions, allowing you to benefit from the stability of fixed rates while enjoying the flexibility of variable rates.

Pros:

• Balanced approach: You get the security of fixed repayments while benefiting from potential rate drops.
• Flexibility: You can still access features like redraw facilities or offset accounts on the variable portion.

Cons:

• Complexity: Managing two portions of a loan can be more complicated.
• Less benefit from rate decreases: Only the variable portion benefits from a rate reduction.

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Repayment type

Monthly

Monthly repayments are the most common and involve making one payment each month, which can be easier for budgeting purposes but will result in paying slightly more interest over the life of the loan.

Fortnightly or weekly

There is a common misconception that opting for fortnightly or weekly loan repayments will pay your home loan down dramatically faster. However, when you select either of these options, banks will annualise your repayments so you won’t be paying any more than if your repayments were monthly. As banks calculate interest daily, you will only save on overall interest paid. 

If you decide to divide your monthly repayments by 4 to estimate weekly repayments, you’ll actually be making extra repayments on the home loan. Let’s take a look at how this works:

With $500,000 loan at 6% for 30 years:

• Monthly repayments $2,988 = $579,191 total interest paid
• Fortnightly repayments of $1,383 = $578,674 total interest paid
• Weekly repayments of $691 = $578,452 total interest paid
• Dividing monthly repayments by 4 to equal weekly repayments of $747 (an extra $56 a week)  = $458,062 total interest paid (which will shave 5.4 years off your loan term)

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Offset account

An offset account is a transactional account linked to your home loan that helps reduce the amount of interest you pay. The balance in your offset account is subtracted from your loan’s outstanding balance when the lender calculates the interest due. For example, if you have a $300,000 loan and $20,000 in your offset account, you’ll only be charged interest on $280,000. This can lead to significant interest savings over time while giving you easy access to your funds, much like a regular savings account.

Pros:

• Interest savings: The more money in your offset account, the less interest you pay.
• Tax advantages: Interest savings are non-taxable, unlike interest earned in a regular savings account.

Cons:

• Higher fees: Offset accounts are typically available with loans that have higher fees, so you’ll need to consider if the amount of money in your offset will save you enough interest in comparison to the fees. 

Example of annual interest savings on a $500,000 loan at 6% for 30 years:

• Offset balance of $5,000 = $24,438 interest savings over 30 years
• Offset balance of $10,000 = $47,517 interest savings over 30 years
• Offset balance of $50,000 = $194,592 interest savings over 30 years

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Redraw facilities

A redraw facility allows you to make extra repayments on your loan and later access those additional funds if needed. This can help you pay off your loan faster while still providing flexibility. The extra repayments reduce the outstanding loan balance, lowering the amount of interest you’re charged. However, redraw facilities often come with restrictions, such as limits on how much or how often you can withdraw, and may sometimes include fees for accessing the funds.

Pros:

• Interest savings: Making extra repayments reduces the loan balance, saving interest over time.
• Flexibility: You can access extra payments if your financial situation changes.

Cons:

• Potential fees: Some lenders charge fees to access redraw funds.

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There’s no one-size-fits-all answer when it comes to choosing a loan. Your decision should be based on your financial situation, lifestyle, and future goals. While a mortgage broker can provide expert advice, understanding the key elements of different loans — principal and interest vs interest only, fixed vs variable interest rates, repayment types, offset accounts, and redraw facilities — will help you make the best choice for you. Keep in mind your risk tolerance, financial discipline, and whether you prefer flexibility or stability when deciding on the best loan option for your needs.