Interested in interest-only loans?

11th October 2006

Interest-only loans give you more cash to play with each month. But if you're not strategic, they can cost you more in the long run.

Let's say you borrow $200,000 to buy a property. Anything you pay off that $200,000 is a principal repayment. That becomes your "equity" - the portion of the property you own. Eventually, you pay off all the principal and own the property outright.

In addition, you pay interest to the bank, calculated according to the interest rate. These payments are pocketed by the bank.Principal-and-interest (P&I) loans are the most traditional loan product, as people tend to be comfortable 'paying something off'. However, with many lenders it's possible to pay interest only. But are interest-only loans a good idea for residential property investors? The answer depends on your circumstances.

Possible advantages

Better cash flow

Instead of, for example, paying $308 per week for a P&I loan (on $200,000 at 7.07% over 30 years), you'd only need to pay $272 per week if the loan was interest only.The improved cash flow (that is, the extra $36 in your pocket) will benefit different people in different ways. But as a property investor, you might use those extra dollars to service a loan on another property.

Pay off your principal place of residence quicker

Chartered accountant Jenny Wilks, director of Pioneer Commercial Services, says, "If you have a borrower who has a debt on a principal place of residence and they're looking to acquire an investment property, by putting the investment property debt on an interest-only basis it allows them to use any surplus cash flow to reduce the non-deductible home loan debt."

Flexibility

Stuart Wemyss of ProSolution executive mortgage brokers says, "Interest only gives you the best of both worlds because most variable rate products allow regular or irregular extra repayments (that is, repayments above the interest-only amount). Therefore, you can switch between interest-only repayments and principal-and-interest repayments if you wish."

Wilks points out: "It may be a beneficial option for people who have lumpy or variable cash flow."Any time you receive a lump sum of income, for example, you can put that money towards a repayment, which effectively reduces your principal.

Better borrowing capacity

"Electing to repay interest only reduces your financial commitment and resultantly can increase your borrowing capacity with some lenders (compared to a loan with P&I repayments)," says Wemyss.

Possible disadvantages

No discipline

There's not much point paying interest only if you're going to blow the extra savings on day-to-day things. An interest-only loan needs to be part of a strategy which will see the excess funds put to good use. This requires planning and discipline.

Harder to build equity

In a booming market, you'll get equity in your property as its value increases. But in a slower market, some people prefer to make principal repayments as a way of building up their equity.

Five-year terms

Most interest-only terms are five years (although some are ten). At the end of the term you can apply to roll the loan over for another five-year period.Wemyss sees this as a positive: "It forces you to review your loan products every five years, to ensure they're still appropriate for you." However, in a depreciating market, it's possible a lender could withdraw from the loan at the end of the loan term. You might then be forced to sell your property at a loss. Wilks points out that this hasn't been very common for residential loans."With the strong growth we've enjoyed in the property market in Australia in recent years, astute investors haven't been subjected to depreciating asset values. As such, investors see very little danger in interest-only facilities," she says.

Pay more interest

"Since you're only repaying interest, you'll end up paying more interest over the life of the loan," Wemyss explains. For example, once your $200,000 loan is paid down to $100,000 - you're only paying interest on $100,000. Whereas if you're paying interest only, you'll still be paying interest on $200,000. However, if you elect to make extra repayments from time to time, or if you keep money in an offset account, the interest can be reduced.

Never paying off the loan

"Some people appreciate the rigidity of principal-and-interest repayments," says Wemyss. "That is, they're 'locked in' to repaying the loan." If you ultimately want to end up debt-free, then at some stage you'll need to pay off the principal.

 

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