If you’re an aspiring investor you are likely knee-deep in research. There are many variables you need to consider, from choosing the best suburb, the type of property and even the type of loan. When it comes to securing an investment loan, you likely have the option to choose between a principal and interest loan or an interest only investment loan, the latter being a common choice for investors. In this blog, we explore the difference between each type of loan and the role they play within your long-term investment strategy.
What is the difference between a principal & interest (P&I) loan and an interest only investment loan?
Okay, great question. Let’s break it down.
A principal and interest loan is where you pay interest and incremental portions of the amount you borrowed – the ‘principal’ – at the same time.
With a P & I loan, you are making payments towards the actual property from day one and overall, it will most likely be a more cost-effective option. As an investor, it’s also a less risky option. You know what your payments are from the start, and you are building equity which may help to support future investments.
An interest only investment loan means just that. You are essentially paying off only the interest on the loan amount. You are not making any payments towards the principal loan amount.
Generally, neither option is better than the other. The right type of loan for you will vary depending on your circumstances and your long-term investment strategy.
What are the benefits of an interest only investment loan?
Interest only loans are one of the ways investors can keep their costs down. In this instance, they are not repaying the loan capital (the principal), so the monthly repayments are lower than a principal & interest loan.
An interest only loan enables you to get into the market and build capital growth while still having access to extra cashflow. At tax time, you may be able to offset the interest you’re paying and eligible property costs against any rental income you receive. By not having to pay the loan principal initially, investors can reallocate those funds towards non-tax-deductible debts and funding other assets, for example, reducing the debt on their principal place of residence.
Inovayt Managing Director Nick Reilly says, “Investment loans are tax deductible, so there is often little point reducing those loans until you have completely paid off your home loan which is not tax deductible.”
What are the risks and ramifications of an interest only investment loan?
In a way, an interest only investment loan is creating a false economy. The low repayments associated can make investment properties appear more affordable than they are and when the interest only period ends, unprepared investors can be caught off guard by a significant increase in repayments.
Interest only loans are also considered a riskier choice. As you aren’t reducing any of the amount you borrowed, you aren’t building any equity within your property portfolio. It also means, in the long run, you’re likely to pay more than you would with a P & I loan.
The Australian Securities and Investments Commission (ASIC) broke down the costs over time. Based on a $500,000 P & I loan over thirty years; the average consumer would pay around $579,032 in interest with a constant interest rate of 6%. If you have an interest only period for a length of 5 years, a consumer will pay around $616,258 in total. That is an additional $37,226 compared to if you had a P & I loan.
Nick points out that while it’s fine to get an interest only loan now, you might be in a different position come five years’ time. Five years ago, you may have had the option to borrow interest only, but things may have changed since then. You may have lost or reduced your income which means there are some associated risks, and you may be left with repayments that are unmanageable. This is when you see forced selling and it means people have to sell at the wrong time and potentially forgo opportunities to build wealth.
If you have an interest only investment loan, what options do you have when the interest only period runs out?
The good news is that there are options, and these may vary depending on your situation and lender.
Refinance: If the end of your interest only period is in sight, it’s worth researching to see if there are other better options available. There might be other more competitive home loans or loans with better-suited features to your needs. In some instances, you may also be able to extend the interest only period. If you are considering refinancing, we recommend speaking with an experienced finance or mortgage broker.
Extend the interest only period: With some lenders, you may have the option to extend the interest only period. However, it’s worth considering what this means for your investment strategy long-term, keeping in mind that this option will likely cost you more over time. You may also have to undergo additional credit checks from the lender to ensure you are still able to comfortably make your repayments. Considering the additional costs and risk, it’s worth speaking with your accountant or financial planner before proceeding as they will be able to help you consider the best short- and long-term strategies.
Switch to a P & I loan: If you are a savvy investor, it’s likely you are already across the ins and outs of your loan. You might be already anticipating your loan will revert to P & I and you welcome this switch. While your repayments will increase it does mean you are paying interest as well as paying down the loan principal.
When it comes down to it, Nick says, “A clear strategy is the most important thing. You need to consider your motivation for investing. Are you planning to purchase a lot of properties because you are a high-income earner and you’re after a tax deduction? If that’s the case, interest only may be the way to go. But, if you only ever want to buy one or two investments, it’s worth considering P & I as you have a safe strategy in place knowing that you will own the property at the end of the loan term in comparison to an interest-only loan where you must review the loan terms every five or so years.”
As you can see, there isn’t necessarily a right or wrong type of loan. Both loan types have advantages and disadvantages. In the end, choosing the right loan type will depend on your current financial situation and your overall investment strategy. Not all investment loans should be interest free loans. While an interest only investment loan frees up your cash flow, over time, it will cost you more in the long run if you don’t seek professional financial advice and plan accordingly.