Get an interest-only investment loan

This article was fact-checked and reviewed by Cam McLellan, a property investment specialist whose book, My four-year-old the property investor, has sold more than 100,000 copies. Content has been updated for 2021.

Interest-only loans end up costing borrowers more in the long run. You delay repaying the full loan amount, which makes your repayments lower in the short term when you just repay the interest. This presents investors with an opportunity because interest payments are tax deductible (payments against the loan principal are not). Investors can use interest-only loans to pay less in the short term while cutting down their tax bill.

What is an interest-only investment loan?

Australia property investors have two options for making repayments on their investment loans.

1.) Borrow the money and repay it plus interest at the same time. This is called a principal-and-interest home loan (principal means the money you've borrowed).

2.) Borrow the money now and pay the interest charges, but avoid repaying the loan principal until later. This is called an interest-only loan.

Interest-only loans are way cheaper at the start because you're only paying interest. But you're not actually making any progress on your loan. This ends up costing you more money in the long run.

And yet it's a popular choice for investors in particular. And if you know what you're doing, an interest-only loan lets you lower your loan costs while maximising your tax-deductible expenses.

How interest-only loans benefit investors

Australian property investors have a tax advantage that home buyers don't. Interest on an investment home loan is tax deductible.

At the end of the financial year, you can deduct all of the interest you've paid on your investment property (along with a number of other tax-deductible property expenses) over the past 12 months.

Let's say you end up spending $20,000 on expenses such as:

• Property maintenance and repairs
• Council rates
• Interest charges on the loan

Over the same time, you've had rental income of $16,000. Because your investment has cost you more than you made (to the tune of $4,000), you can deduct the loss from your taxable income.

Ultimately you want to generate profit your investment. But even your losses are tax deductible, which can really help you out in the short term. To learn more about how this works, read our guide on negative gearing.

Cut your short-term costs

Making interest-only repayments does cost you more in the long run. But what if you're short on cash right now? This could be because you've lost a job, or your property is without tenants and there's no rent coming in.

If you have an investment property but suddenly find you can't meet the principal-and-interest repayments, switching to interest-only could be a life saver.

Here's a simple example. Let's say you've borrowed $600,000 over 30 years with a rate of 2.30%.

It will cost you more over the life of the loan, but switching to interest-only for a few months in this scenario would save you $1,158 a month.

Compound growth strategy

Some investors buy property with a high-growth strategy by choosing properties and locations they believe will grow quickly in value. Rather than holding the property for many years, renting it out and paying it off over time, these investors buy the property, minimise their repayments for a few years, then sell the property for a much greater amount than they paid.

For this strategy to work, an interest-only investment loan is essential because your repayments are much smaller at first.

Here's a completely hypothetical example. Let's assume bought a $700,000 investment property in a booming market. You had a 20% deposit, or $140,000. Your loan principal is therefore $560,000.

Assuming a 30-year loan and an interest rate of 2.30%, your monthly repayments on an interest-only home loan would be $1,073.

Now let's assume the investment grows in value at 7% per year for 4 years. You can sell the property for $917,000.

And in those 4 years you haven't paid off the loan at all, but you've only paid $51,504 in interest. Accounting for the original value and the interest paid, you still come out over $160,00 ahead.

Of course, this is very simplified example and doesn't include your selling costs and stamp duty, plus the capital gains tax if you sell. It also doesn't take rental income into account, which could offset the interest costs (and if the property costs you more than you made in rent you could reduce your tax bill).

Need expert help? Contact a mortgage broker

What are the risks of interest-only loans?

It's a good idea to consider the risk or negatives when making any financial decision. Then you're able to balance out the pros with the cons to make the right decision for you. Interest-only loans have a few possible drawbacks:

• Interest-only loans have higher interest rates. While your repayments are smaller at first, lenders charge higher rates for interest-only loans. The lowest rates on the market are always principal-and-interest loans. When your loan reverts to a principal-and-interest loan, make sure you're rate is lower too.
• With interest-only loans, you won't reduce your debt during the interest-only period. At the end of the interest-only period, you'll still owe the same amount you borrowed. For instance, if you borrow $500,000 on an interest-only loan, two years later, you'll still owe $500,000 on that loan.
• Your repayments rise significantly once your loan reverts to a principal and interest loan. This is because you now need to pay off the principal in the remaining loan term, after a period of making no headway with the overall balance. As in our previous example, if you had an interest-only loan worth $500,000 for 2 years, you would then repay the $500,000 principal (plus interest) over the remaining 28 years of the 30-year loan term. One way to get around this is to refinance the loan to a fresh 30-year term, although this means it will take you longer to own your home outright.
• Interest-only home loans can also be risky if your property fails to increase in value. This means when the interest-only period ends, you won't have as much equity in your home as you'd have if you were chipping away at the principal with a standard principal and interest loan.

None of this means interest-only loans are inherently bad or risky. You just need to be aware of the potential downsides and make sure your investment strategy suits your loan type. Getting expert help from a mortgage broker is a good idea if you're confused about interest-only investment loans.

How do I compare interest-only investment loans?

When comparing interest-only mortgages for investment, you need to consider these factors:

• Interest rate. A lower rate means lower repayments. It's one of the fastest ways to compare mortgages. If 2 loans are equal in all other respects (fees, features, eligibility criteria), the one with the lowest rate is better for you.
• Offset account. Having an offset account lets you use additional savings to reduce your interest payments even further. Investors can really take advantage of offset accounts by building up savings and reducing their loan while still maximising their tax-deductible expenses.
• Flexibility. A loan with low fees (especially discharge and switching fees) makes it easier to refinance your mortgage when the interest-only period ends. And why pay more in fees when you can avoid it?
• Structure. Structure is the most important factor when choosing your investment loan. Do not cross-secure your investment loans with the home loan on your own personal home.

Use a repayment calculator

Use a loan repayment calculator =to find out what your repayments will be if you choose an interest-only home loan. Then run the same calculations for principal and interest repayments so you can see what your repayments will be once the interest-only period ends. You’ll need to pay attention to both repayment figures and determine if you’ll be able to service the new repayments once your interest-only period ends.