principal and interest
  • There are some things in life where you nod your head as if you are supposed to understand, but don’t really.
  • In my mortgage broking experience, I found a the majority of borrowers lack an understanding of how principal and interest works.
  • Once you understand how principal and interest works, you can be one step closer to applying some effective repayment hacks.

What is it principal and interest?

Principal and interest repayments are considered the classic type of repayment for borrowers with a home loan.

Each principal and interest (banks commonly refer to this as P&I) repayment is usually made up of:

Principal – An amount that reduces the balance owed on a home loan.

Interest – The cost of the loan due to the interest rate. This is usually calculated daily and charged monthly.

A minimum P&I monthly repayment is usually outlined under Australian home loan agreements.

How principal and interest works

It costs banks money to lend money. While lenders have various ways of charging for home loans, interest is the main one.

So, lenders collect interest along the way as borrowers pay down the loan over the loan term. In Australia, home loan terms are commonly 25 to 30 years.

Home loans with principal and interest repayments require a minimum monthly P&I repayment, specifically designed to reduce the amount owing to zero by the end of the agreed loan term.

In the example below the minimum P&I repayment for a $600,000 home loan at 7% is $4,421 per month for 25yrs.

The principal component of the first minimum repayment (month one) is $741, month two is $745, and so it goes.

How principal and interest works - First repayment

Fast-forward to the 10 year mark of the loan and the repayment is the same amount – but different in make-up. The principal portion of the P&I repayment has increased to $1,480. This is why the loan balance will reduce at a faster pace as time progresses.

How principal and interest works - 11th year repayment

As you can see, the more the loan balance reduces, the more principal is paid off each month.

How principal and interest works - how much is principal
Figure: Principal and interest repayments reduce loan amount over term

Although the minimum repayment remains the same, the principal amount within the repayment make-up increases over time.

Why?

Because interest is calculated in the balance owed. The lower the home loan balance, the lower the interest component within the P&I repayment.

If no extra payments are made over the course of the loan then it will take 25 years to reduce this loan to zero.

That’s how principal and interest works.

There are many ways to shorten your loan term and pay less interest. In my article I share examples of how to pay off your mortgage faster.

Having been in involved in mortgage broking since 2008, I have helped many borrowers understand the concept of principal and interest, and specifically, how interest is calculated.

How borrowers apply their understanding to spending and saving behaviours is where can make a meaningful difference to how much they pay in interest costs. My article on how interest is calculated explores this further and as well as where to find interest on your statements.

How are principal and interest repayments calculated?

Principal and interest repayments comprise of principal (to reduce the loan), interest and fees. The calculation of the minimum required monthly repayment uses the following numbers:

The loan limit is the size of the loan facility and is comprised of the loan balance plus any advanced payments, known as redraw. The loan limit is used to calculate the minimum monthly repayment.

It differs from the loan balance which is used in interest calculations.

The interest rate is expressed as an annual percentage. It is broken down to a daily interest amount for the sake of calculating daily interest charges.

In Australia, home loans are commonly over 25 to 30 years.

If any of these variables change then the minimum requirement monthly repayment will also change.

The below illustration shows how changes to loan term or interest rate will affect the principal and interest repayment calculation.

Changes that impact how principal and interest repayments are calculated.

This example shows how different home loan variables, like interest rates, can cause the minimum principal and interest repayment to change. It is worth highlighting that minimum repayments are just that. The bare minimum designed to take a borrower through to very end of the loan term. This can be a long time for a lot of people.

My article on repayment hacks explores how seemingly minor changes can have a big impact in paying off your loan—ahead of time.

What loans can have principal and interest repayments

Many Australian home loan products come with two repayment options, principal and interest or interest only. Home loans with principal and interest repayments are said to pose less risk to lenders than interest only repayments.

Home loans with a principal and interest repayment type are preferred by many Australian lenders with less hurdles to approval. Further, the Australian banking regulator, APRA, requires lenders to monitor exposure to each repayment type.

Home loan by purpose

Both investment and owner-occupied home loans can have principal and interest as a repayment type.

Principal and interest repayments are more commonly used by home owners who want to reduce their debt. In some instances, borrowers, will opt for an interest only repayment type to compliment an investment strategy.

Home loan by product

Both variable and fixed rate home loans can have principal and interest as a repayment type.

This can be a source of confusion but I explain it this way:
Fixed and variable are types of home loan products.
P&I or interest only determine how you want to pay for them.

Line of credit

A line of credit can also be referred to as home equity line or equity access product. By their very nature no principal is required to be paid down so P&I is not an option on most genuine equity access products.

What are principal and interest repayments good for?

The home loan scenarios likely to benefit from having principal and interest repayments share common borrower objectives around low rates or desire to eliminate debt—or both.

Low interest rates

Who wouldn’t want a low home loan rate? The catch with low rates is they they often require loan scenarios to fit in terms of loan amount, loan to value ratio and repayment type.

Given lenders and regulators regard the principal and interest repayment type as low risk they generally set these rates lower than the interest only alternative.

Insider note: If you don’t pay attention to your rates you could be in the unfortunate situation where you have a principal and interest rate higher rate than an interest only rate – not the way the system is intended to work. I share a way for borrowers to ask for a lower rate in my Insider Guide.

Build up equity

Principal and interest repayments help borrowers work on building up equity from the start. This is one thing withing their control, as opposed to relying on property values increasing.

Owner occupiers

Many owner occupiers have an objective of paying off their home loan as fast as possible.

A principal and interest repayment type checks this box given it requires principal reductions to the debt, and is usually at a lower home loan rate than the interest only alternative.

Investors

For many years, interest only was the repayment ‘go to’ for borrowers with an investment property strategy.

Regulation changes in Australian lending means interest only loans have become more difficult to acquire for some scenarios. They can also attracted higher rates.

So, principal and interest repayment is a good choice for investors who see the benefits of lower rates and regular repayments that build up equity.

Your only option

Principal and interest repayments can be the only option offered in some lending scenarios.

The lower risk nature of a home loan with principal and interest repayment can help offset higher risk factors such as a low deposit.

Heard of recasting repayments?

This is a bank term that describes a recalculation of P&I repayments that see repayments lowered to align with the original loan term.

An example of where this applies is when a borrower is ahead on repayments and on track to pay off their loan at year 18 instead of the original 25 years.

By recasting their mortgage, their repayments are reduced so that the mortgage is paid out over the original 25yrs.

On one hand borrowers benefit from lower monthly repayments and can maximise any spare cash.

BUT….

Recasting your mortgage can cost a borrower significantly more in interest as they can have the loan for longer.

Principal and interest vs interest only

Principal and interest repayments reduce the loan limit over time.

Interest only repayments do not require any reduction in loan principal during the interest only period. Borrowers only pay the interest costs (plus any other fees and charges) and the loan balance remains the same.

One key consideration for an interest only repayment option is that lenders often require the home loan to revert to P&I repayments. Given some of the loan term has been used for an interest only strategy there is less time to reduce the loan – resulting in higher repayments compared P&I from the beginning.

I explore the ins and outs of principal and interest vs interest only here.

What happens to P&I repayments after a rate discount?

Banks differ in their approach to adjusting principal and interest repayments after an interest rate discount.

Borrowers should know they have options. They should not assume changes like this are always made with their goals and objective in mind.

A few things can happen.

Reduction in minimum repayment

The minimum requirement repayment can decrease, but that is something borrowers should make a conscious decision around because this short-term decision can have long-term consequences.

If you did reduce your minimum repayment amount do the savings all end up in your wallet? No.

While there can be a reduction to the required minimum repayments, it will not match the amount of interest saved.

Why?
The reduced interest costs allow for more principal to be directed towards loan reduction, increasing property equity.

Keep the repayments the same

By keeping the repayments the same you still enjoy the interest costs savings. You are also paying over the required minimum repayments.

This has two really positive impacts for those looking to pay off their home loan:

An example of P&I after a rate reduction

It could be that you have proactively requested the discount yourself, or the bank has reduced the rate for you home loan product.

A reduced home loan interest rate can enable a lower minimum repayment. But lenders do not always apply the minimum repayment to your home loan account automatically.

Borrowers should know they have options. They should not assume changes like this are always made with their goals and objective in mind.

The below example highlights how significant small choices around principal and interest repayments can be.

Have a look at the scenarios below.
Loan remaining is $600,000
Term left is 25yrs
Rate has just been reduced from 7% to 6%

How principal and interest works - minimum vs accelerated repayments
Figure Loan term comparison for minimum vs accelerated repayments

One scenario shows loan reduction over the years if the new reduced minimum repayments are adopted.

The other shows the impact of staying on the existing repayment amount (as if the rate was still 7%).

Not reducing the monthly repayment could see the loan paid out over 4 years earlier. Not to mention that by paying out the home loan earlier there is about $114,000 in extra interest savings as well.

This is academic as in reality borrowers try to make overpayments where possible. Borrowers will probably refinance or sell before there loan term is up. The concept remains though, higher than minimum P& repayments can reduce your loan term and overall interest cost—these amounts can be significant.

Your choice is your choice but make sure you get involved. Don’t let the loan go onto autopilot when you can be part of some very important decision-making. Being proactive can save yourself—time and money.

Food for thought?

Final word

Understanding how principal and interest works is key to understanding how to reduce your home loan interest costs.

Don’t always assume changes to minimum repayments are made with your objectives in mind. Get involved with proposed repayment changes and make sure they suit where want to get too—financially.

I explain further hacks for borrowers to reduce their home loan ahead of time in my article on home loan hacks.

This is not an area you need to deal with on your own. It can be tricky and confusing. That is why there are qualified and professional mortgage brokers to guide you through any decisions regarding home loan repayment strategies.

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