When you purchase a property, there are two types of mortgages you can select from: an interest-only mortgage or a principal and interest mortgage, which is also known as a repayment mortgage in some countries.
What is the difference?
‘Principal’ is the amount you borrow from the lender. For example, I buy a $100,000 house with my $10,000 deposit and a $90,000 loan from the bank. The principal amount is $90,000.
‘Interest’ is the amount the lender charges you for the loan. Each lender sets their own interest rates. For example, the bank might charge a 3.7% annual interest rate on the $90,000 loan, which has to be repaid either weekly or monthly.
Receiving interest repayments is how companies profit from lending you money.
When you opt for a principal and interest mortgage (repayment mortgage), your weekly or monthly repayments continuously reduces both the principal amount and the interest you owe. This means your overall mortgage debt decreases with each repayment.
When you opt for an interest-only mortgage, only the interest is repaid, but the principal amount remains the same. You are expected to pay off the principal amount, that is the $90,000 loan, in one lump sum when the mortgage ends.
Which mortgage is better for a new property investor?
Though there are many pros and cons for both types of mortgages, I think it’s ‘safer’ to opt for a principal and interest mortgage when purchasing your first property.
That’s because, as a new investor, you need to spend more time learning about the property market. And in this period, I feel it’s better to be more risk-averse until you gain more experience and knowledge. Many investors may dispute this view.
When you finance your first property with a principal and interest mortgage, like I did with my first two investment properties, you know that your debt is reducing. Thus, you can be more confident that your loan will be paid off when your mortgage ends.
When you’re ready to invest in a second or third property, you might want to consider financing these additional investments using an interest-only mortgage.
The repayments for an interest-only mortgage is lower than a principal and interest mortgage, so you keep more of your cash in the bank. This is also why my husband and I opted for an interest-only mortgage for our third and fourth properties.
Many people believe an interest-only mortgage is better because you can ‘easily’ save the amount of the mortgage loan over many, many years. Unless you’re very rich or are exceptional at saving money, to me, this is wishful thinking.
Have you ever tried to save $200,000 in cash? If so, good on you! For many people, myself included, this probably isn’t going to happen.
Also, you can’t predict what might happen later in your life that could limit your ability to save money, such as: having children; paying for education funds; bankruptcy; divorces; health issues; looking after an elderly parent; redundancies; etc.
Sell one property to pay off two mortgages
I believe the most realistic and effective way to pay off a property financed with an interest-only mortgage is owning two properties. You sell one property when the value increases high enough, to pay off the mortgages for both this and the second property.
Alternatively, when interest rates decrease, you could consider switching from an interest-only mortgage to a principal and interest mortgage, to avoid paying a large lump sum when the mortgage ends. We plan to do this for one of our properties.
There are many ways which you can use these two types of mortgages to your advantage. My method, described above, is just one of many suggestions.
You should research how other investors are benefiting from both types of mortgages, then decide what would work best for your investment strategy and financial situation.
So, do you prefer an interest-only mortgage or a principal and interest (repayment) mortgage?
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Please note, though I own a few properties, I am not a legal, financial or professional property expert. I’ve written this post to share my personal experiences and would love to hear your opinions and views.