Property investing with an interest-only loan
After having decided to invest in property you need to decide whether to take out an interest only or a principal and interest loan.
The loan product of choice for most property investors is interest-only; allowing them to preserve cash flow and afford to hold more investment property than they otherwise would be able to.
With an interest only loan a borrower, usually a property investor, services the interest component of the loan but does not pay down any of the principal. That means that after five, 10 or 20 years of interest only repayments the amount owing is exactly the same as it was when the loan was first taken out. To some this may seem like a negative, however, in real terms inflation has actually diminished the true value of your debt - much the same way inflation reduces the purchasing power of $1,000 over time.
The interest component of an investment loan is tax deductible so many property investors choose to maximise their tax deductible debt and redirect any additional cash flow they may have towards reducing non (tax) deductible debt.
If in the year 2000, for example, you had borrowed $180,000 towards the purchase of a $200,000 property and had been making interest only repayments ever since, although you would still owe the same $180,000 today, in real terms, your debt would have diminished. Yes, the $180,000 debt has the same face value as it did back in 2000, but its purchasing power today and its value as a percentage of the current value of the investment property purchased would have decreased.
So even property investors with interest only loans who choose not to pay down their debt, will see time and inflation reduce their debt (in real terms), if they simply hold onto their investment property for the long-term.
So if you have been conditioned to pay down all debt, that is even tax deductible debt, one could argue that to do it at some time in the future, after inflation had worked in your favour, will leave you financially better off.
The wealthiest and most astute property investors seek to growth their equity through the capital appreciation of the investment properties. While cash flow is an important part of an investor’s ability to hold onto their investment property portfolio, it tends to be a secondary objective.
Standard home loans are known as principal and interest loans. Principal and interest loans are the most common way homeowners finance their owner occupier properties, where personal debt is non tax deductible.
A small part of your monthly principal and interest loan repayment is directed to paying down the principle amount you borrowed, with the larger residual servicing the interest. When interest rates are reduced your lender will notify you and tell you what your new reduced monthly repayment amount will be. If, however, you were to continue to pay the same amount onto the loan then the amount going towards reducing the principal debt would increase, allowing you to pay off the loan faster.
Why an interest-only loan?
A principal and interest loan requires you to pay two amounts:
- A payment for the principal amount borrowed on the loan, and
- A payment for the amount of interest charged to borrow the finance for the loan
With an interest only loan you are only required to make payments to cover the interest component of the loan; that is the interest on the principal amount borrowed.
Borrowing on interest only arrangements is considered beneficial by those investing in property. As an investor this type of arrangement allows you to minimise your outgoings to what’s absolutely necessary to hold your investment property.
An interest only loan assists with cash flow making it easier to afford a negatively geared property. The additional cash flow saving may be the difference between having been able to afford to hold the property or not, or it may mean the difference between investing in one or two investment properties vs. three or four, for example.
Where a negatively geared property delivers positive cash flow, or in the case of a positively geared property itself, only paying the interest component of a loan adds to cash flow.
Your difference in repayment between an interest only and a principal and interest loan will depend on the amount of the loan, the term (number of years) of the loan, the size of your deposit, whether or not there was Lender’s mortgage Insurance (LMI) payable, and if so how much and of course any difference in interest rates between the two.
Your loan-to-value ratio (LVR) is the correlation between what you borrowed and what the investment property is worth. This will impact your repayments if you borrow over 80% of the investment property’s value and LMI kicks in. It could also reduce your repayments if your LVR is kept low. That is, a bigger loan with a smaller LVR would put a property investor in a strong position to negotiate a cheaper interest rate.
Types of interest-only loans
Typically there are two types of interest-only loans that property investors choose.
Interest in advance
With an interest in advance loan, the interest is charged to the investor at the beginning of a specific period of time. For example, charging the first year’s interest in the first month of a loan. It’s generally only available on fixed-rate loans for investment purposes.
Interest in arrears
Interest in arrears is the more common loan type where the interest is charged at the end of a period of time, which is normally at the end of the month.
If you would like to speak to an MRD Finance Specialist about your situation, please call us on 1300 883 854 or contact us now