Interest only vs principal and interest: the Australian decision in 2026

An interest-only loan does not save you money. It defers repayment of the principal and charges you a higher rate for the privilege. The reason a third of investor lending in Australia is still written interest-only is not that the product is cheap. It is that for a highly geared investor with a deductible loan, paying down principal is the worst use of a dollar of after-tax cash they have.

For almost every owner-occupier, the same product is a slow leak. Here is what IO actually is, why banks price it higher, the one borrower who legitimately benefits, and the cliff waiting at the end of the IO period that catches people who treated the low repayment as the normal repayment.

What interest-only actually means

On a standard principal-and-interest loan, every monthly repayment is split between interest charged for the month and a chunk of principal paid down. The balance falls a little every month. After thirty years it hits zero. That is the whole loan.

An interest-only loan replaces the first one-to-five years of that schedule with payments that cover interest charges and nothing else. The principal balance at the end of the IO period is identical to the principal balance on day one. The loan has not amortised at all. When the IO period expires the loan reverts to P&I, but on the remaining term, not a fresh thirty-year clock.

Australian lenders cap IO at five years for owner-occupiers and ten years for investors, and most require a fresh serviceability assessment to extend beyond the original IO period. There is no such thing as a thirty-year IO loan in retail Australian mortgage lending.

Why IO costs more per dollar borrowed

APRA leaned heavily on the major banks in 2017 to limit IO new lending to 30% of total flow and never softened the underlying capital-charge framework that came with it. The practical result is that IO loans carry a rate premium of 30 to 50 basis points above the equivalent P&I product at every major bank, with another 5 to 15 basis points on top for investor IO compared to owner-occupier IO.

Worked example on a $600,000 loan with a 30-year term. The P&I rate is 6.20% and the IO rate from the same lender is 6.55%. The P&I repayment is $3,679 a month, of which roughly $3,100 is interest in the first month. The IO repayment is $3,275 a month, all of it interest. So the IO statement looks $404 cheaper.

Over a 5-year IO period the borrower pays $196,500 in interest. Over the same 5 years on the P&I loan, they pay roughly $182,800 in interest and reduce the principal by $38,400. The IO borrower ends year 5 with $600,000 still owed; the P&I borrower ends year 5 with $561,600 owed. The IO loan has cost $13,700 more in interest and put the borrower $38,400 further behind on the balance. The mortgage repayment calculator is the fastest way to sanity-check this with your own numbers.

The investor case for IO

The Australian Tax Office allows a deduction against rental income for the interest paid on a loan used to acquire an income-producing property. Principal repayments are not deductible. They are just you giving the bank back its money.

For an investor on the 37% marginal rate, $1 of interest paid is effectively $0.63 of after-tax cost. The same dollar spent paying down principal is a full $1 of after-tax cost with zero tax shield. IO maximises the deductible portion of the loan for as long as possible and keeps the principal balance high, which is exactly the position a leveraged investor wants if they believe the property will appreciate and they have better uses for their cash elsewhere.

Those better uses usually fall into two buckets. The first is debt recycling: directing the spare cashflow that would have gone to non-deductible principal repayments toward clearing a non-deductible debt instead, typically the home loan on the owner-occupied residence. The second is deploying the freed cashflow into the next deposit. Either way the structural point is the same: an investor with non-deductible debt elsewhere should not be paying down deductible debt voluntarily.

The cashflow effect is real. Our $600,000 example loan running IO frees up $404 a month of cashflow versus P&I. Across the 5-year IO period that is $24,240 redirected to the next investment, the offset against the home loan, or simply held as a buffer against vacancy. See negative gearing in 2026 for the wider tax picture that sits behind this trade.

The owner-occupier case for IO (it is narrow)

Most owner-occupiers should not run IO. The principal repayments are not deductible against anything, so the only thing IO buys you is a lower monthly payment in exchange for a higher rate and no progress on the loan. That is a bad trade unless you genuinely need the cashflow relief for a defined period.

Legitimate use cases are short and specific: parental leave where one income drops to nil for 6 to 12 months, a known redundancy or career-transition window, or bridging finance between selling and buying. In each case the IO period is a deliberate gap, not the long-term structure of the loan, and the borrower flips back to P&I (or repays the bridging facility outright) as soon as cashflow normalises.

Lenders know this and most cap owner-occupier IO at 1 to 2 years without a documented reason. Extending it requires a fresh assessment and usually a refinance.

The IO-expiry trap

This is the part that surprises people who took IO five years ago because the repayment fit and never modelled what happens at expiry. When IO rolls to P&I, the loan does not reset to a 30-year amortisation. It amortises over the remaining term, which is now 25 years.

Same $600,000 loan. The IO payment was $3,275 a month at 6.55%. On day one of the post-IO period, the loan reverts to P&I at, say, 6.20% over the remaining 25 years. The new repayment is $3,950 a month. That is a 21% jump on the IO payment, and roughly a 7% jump on what the borrower would have been paying if they had taken the P&I product from the start ($3,679 on a 30-year term).

The compression effect gets worse with longer IO. A 10-year investor IO loan reverting to P&I over 20 years on the same numbers lands at $4,367 a month, a 33% jump on the IO payment. Borrowers who scraped through serviceability on the original IO repayment routinely fail the reassessment when they apply to extend. The lender then either declines the extension and forces the loan into P&I on the remaining term, or the borrower refinances elsewhere on whatever rate and term they can get, which is often worse.

The APRA buffer at IO expiry

Refinancing or extending IO triggers a full serviceability re-assessment under APRA's 3-percentage-point buffer. The buffered rate on a 6.20% P&I loan in 2026 is 9.20%, and the bank tests whether your income can support the stressed P&I repayment on the remaining term, not the actual IO repayment you have been making. Five years of wage growth that lagged interest-rate rises is a common reason this fails, even for borrowers whose situation has otherwise improved.

The cleanest version of this for an investor is to plan the IO period as a single-purpose window, not as an open-ended deferral. Know the date the loan reverts, model the post-IO repayment at the buffered rate, and have a plan that either sells the property, refinances on terms you have already sanity-checked, or absorbs the higher repayment from current cashflow. The APRA serviceability buffer article walks through how the assessment math actually runs.

Tax-deductibility nuance for investors

The interest paid on an investor IO loan is fully deductible against the rental income of the property, assuming the property is genuinely available for rent. That much is uncontroversial.

What trips investors up is what happens when an IO loan is eventually paid down. A $50,000 principal repayment on a deductible IO loan does not reduce taxable income by $50,000 the way a deductible interest payment would. It just reduces the loan balance, which reduces future deductible interest going forward. The benefit accrues slowly across the remaining life of the loan, not in the year of repayment.

The corollary is that voluntarily paying down deductible debt before non-deductible debt is the wrong order of operations. Most investors with both should be running the investment loan IO (or P&I with offset against the home loan, not the investment loan), directing every spare dollar of cashflow at the non-deductible owner-occupier debt, and revisiting the structure once the home loan is cleared.

The decision in one paragraph

Owner-occupier with no investment property, no plan to rent the place out, and a stable income: take P&I and save the rate premium. Owner-occupier with a defined cashflow gap on the horizon: take IO for the length of the gap and no longer. Investor with non-deductible debt elsewhere (especially a home loan): take IO on the investment loan, run an offset against the home loan, and direct the cashflow saving at the non-deductible balance. Investor with no other debt and no immediate growth ambitions: take P&I and let the property pay itself down. The loan comparison calculator and our companion piece on offset vs redraw are the next two things to read once the IO vs P&I call is made.