What is an interest-only investment loan?
Investors can use investment loans to borrow money to purchase investment properties. Like other mortgages, the typical structure of a loan requires the borrower to pay back the money (the principal) plus interest charges at the same time. These are principal-and-interest loans.
But interest-only loans allow borrowers to delay repaying the principal for a set period. This results in lower repayments upfront but higher repayments later.
What are the benefits of interest-only investment loans?
Interest-only mortgages are popular with Australian property investors despite being more expensive than principal-and-interest loans. Used correctly, these loans let property investors maximise their tax-deductible interest costs or take a temporary break from making full repayments in an emergency.
Some ambitious investors even use these loans to hold investments cheaply for a few years and then flip them for a fast profit.
Interest payments are tax-deductible
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 property expenses such as repairs, council rates and interest charges on the loan.
Over the same time, you've had a 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.
You can cut your short-term costs
If you own an investment property and want to hold it for a long time and get income from rent, interest-only repayments are not a long-term solution.
But what if you've lost your job, or your property is under repair and has no tenants paying you rent? Switching to cheaper interest-only repayments can be a lifesaver when you're short on cash.
Here's a simple example. Let's say you've borrowed $600,000 over 30 years with a rate of 5.09%.
- Principal-and-interest repayments = $3,255 a month
- Interest-only repayments = $2,545 a month
It will cost you more over the life of the loan, but switching to interest-only repayments would save you $710 a month. In an emergency, that's pretty helpful.
Chasing a high-growth investment strategy
This is a riskier interest-only strategy. Let's say you buy an investment property in a booming market.
Your goal is to hold the property for just a few years, watch it (hopefully) grow in value, minimise your costs in the short term and then sell for a profit.
This is where you want an interest-only investment loan. You don't care about paying the loan off. You want to surf the wave of rising prices and jump off quickly. It's high-risk, high reward.
Example: high-growth investing with an interest-only mortgage
Let's assume you bought a $700,000 investment property in a booming market. You had a 20% deposit, or $140,000. Your loan principal is $560,000.
Assuming a 30-year loan and an interest rate of 5.09%, your monthly repayments on an interest-only loan would be $2,376.
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. You've paid $114,048 in interest. Accounting for the original value and the interest paid, you still come out over $100,000 ahead.
*There are many assumptions in this hypothetical example. Future growth is never guaranteed and this simplified example doesn't include your selling costs, stamp duty, capital gains tax or rental income.
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.
- Higher interest rates. Lenders charge higher rates for interest-only loans, and even higher rates when these are also investment 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 get a lower rate too.
- 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, 2 years later, you'll still owe $500,000 on that loan. And if your property doesn't grow in value, you won't have built much equity in your home because your debt hasn't changed.
- You pay more interest. By avoiding paying off the loan principal during the interest-only period you just end up paying more interest in the long run. You still have to pay off the loan. But by delaying the full repayments your lender gets an opportunity to charge you more interest (at a higher rate too).
How do I compare interest-only investment loans?
When comparing interest-only mortgages for investment, you need to consider these factors:
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.
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 loans while still maximising their tax-deductible expenses.
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?
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.
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Why you need to know when your interest-only period ends
If you aren’t paying attention to when your interest-only period ends, you could find yourself facing higher repayments or a shorter loan term.
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