Interest-Only vs Principal and Interest: What's the Real Difference?
Why owner-occupiers and investors use interest-only loans so differently, the APRA cap on interest-only lending, a worked example, and the repayment jump when it ends.
By Timothy Hirou GaschereauPublished 7 min read
Try it yourself
Interest-only sounds like the cheaper option because the monthly number is smaller, which is exactly the part of the picture that's easy to misread. This is part of a wider guide to property and debt on Snowball Invest.
Quick answer
Principal and interest repayments pay down both the loan balance and the interest, building equity from day one. Interest-only repayments cover only the interest for a set period, commonly one to five years for owner-occupiers and up to fifteen for investors, leaving the full balance untouched and usually carrying a higher interest rate.
In this guide
- →The real difference, and who actually uses interest-only, and why
- →A regulatory cap on interest-only lending most people don't know exists
- →A full worked example, and just how large the repayment jump is when the period ends
🔍 The real difference
| Principal and interest | Interest-only | |
|---|---|---|
| Monthly repayment | Higher, reduces the balance | Lower, balance stays the same |
| Equity built | Grows every repayment | None during the interest-only period |
| Typical interest rate | Standard rate | Often around 0.30% higher |
| Common maximum period | Full loan term | 1-5 years (owner-occupier), up to 15 (investor) |
🙋 Who actually uses interest-only, and why
The split by borrower type is stark: only around 3% of owner-occupier loans are on interest-only repayments, compared with roughly 29% of investor loans. The reason is largely tax-driven, investors can claim interest as a deduction against rental income regardless of whether they're paying down the principal, so many prioritise maximising cash flow or directing extra money elsewhere (like their own home loan, which isn't tax-deductible) over voluntarily reducing a deductible investment debt. This is the same logic behind why using equity to buy an investment property often pairs with an interest-only structure.
📉 What Is Negative Gearing?
The tax mechanics behind why investors lean toward interest-only more than owner-occupiers.
🏛️ The regulatory cap most people don't know exists
Interest-only lending isn't unlimited across the banking system. APRA, the regulator overseeing Australian banks, caps interest-only lending at a maximum of 30% of each lender's new residential mortgage flow, a macroprudential rule introduced specifically to limit how much higher-risk, non-amortising lending banks can write. It's part of why getting approved for an interest-only loan, particularly as an owner-occupier, involves more scrutiny than it once did.
🧮 A worked example
On a $600,000 loan at a comparable rate, five years of interest-only repayments leaves the full $600,000 balance untouched, with the borrower having paid interest only that whole time. Five years of principal and interest repayments over the same period would have reduced the balance by a meaningful amount, building real equity, while typically paying a slightly lower rate along the way. The interest-only path isn't wrong, it's a genuine trade-off, cash flow now versus equity and total cost later.
🏠 Real Loan Cost Calculator
See the actual total interest cost difference for your own loan amount and rate.
⚠️ The catch when the interest-only period ends
🎯 The essential: The RBA's own analysis puts the typical repayment jump at 30-40%, even after accounting for the lower rate a principal and interest loan usually carries.
Once the interest-only period expires, repayments switch to principal and interest, recalculated to repay the full remaining balance over whatever's left of the loan term, often a much shorter window than the original loan length. That compresses years of principal repayment into fewer remaining years, which is exactly why the jump in repayment amount at that point can be significant, and is worth planning for well before it happens rather than being surprised by it. It's also a natural point to reconsider whether fixed, variable or split still suits the loan going forward.
The Reserve Bank has quantified this directly: its analysis of borrowers switching from interest-only to principal and interest found the typical increase in required repayments runs around 30-40%, even after the switch to a lower headline rate is factored in. It's not a hypothetical risk, the RBA has separately noted that the switch is heavily concentrated, with tens of billions of dollars' worth of interest-only loans converting to principal and interest in any given year, meaning it's a well-documented, recurring feature of the mortgage system, not a rare edge case. Building the eventual step-up into a household budget years in advance, rather than assuming the current lower repayment is the permanent number, is the practical lesson from that research.
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❓ Frequently asked questions
Is interest-only always cheaper?
+
Only in monthly cash flow during the interest-only period, since none of the repayment reduces the principal. Over the life of the loan it's more expensive overall, both from paying interest on a higher balance for longer and from the typical rate premium on interest-only loans.
How long can an interest-only period last?
+
For owner-occupiers it's generally limited to one to five years. For investment property loans, some lenders allow up to fifteen years, reflecting the tax-driven reasons investors more commonly choose it.
Why do interest-only loans usually have a higher rate?
+
Lenders price in the additional risk of a loan balance that isn't reducing over the interest-only period, plus regulatory capital requirements that treat interest-only lending as higher risk. The premium is commonly around 0.30% above an equivalent principal and interest loan.
What happens automatically when the interest-only period ends?
+
Repayments switch to principal and interest, recalculated to repay the full remaining balance over whatever's left of the loan term, which is why the jump in repayment amount can be significant if it wasn't planned for in advance.
📚 Recommended reading
The Barefoot Investor
Scott Pape
Australia's best-selling money book ever. A simple system for accounts, budgeting, debt and a real emergency fund in one.
Some links above are affiliate links. If you buy through them, Snowball Invest may earn a small commission at no extra cost to you. We only recommend books we'd suggest anyway.
Sources
- 1. Principal and interest vs interest-only home loans Australia, Mozo
- 2. APRA Insight, Issue 4 2017, Australian Prudential Regulation Authority
- 3. The Expiry of Interest-only Loan Terms, Statement on Monetary Policy, Reserve Bank of Australia
- 4. Interest-only home loans, Moneysmart, Australian Securities and Investments Commission
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Timothy Hirou Gaschereau
Founder of Snowball Invest, not a financial adviser.
I write about what I'm learning myself, because nobody ever taught us how to take control of our own money. It's a skill, not a mystery, and it's never too late to learn it. The best day to start was yesterday, the second best is today.
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