Affordability is not an investment strategy. In fact, it may come at a significant cost.
The financial stability of a property investment strategy over time is important.
However, some interest-only strategies may be putting borrowers at greater financial risk.
Investors should be aware of and consider all of their options when choosing a financial plan.
Interest-only home loans receive a lot of attention, however, it’s not commonly known that in the first years of a principal and interest loan, the majority of the repayment amount is also interest.
For many people, an interest-only home loan will seem like a great idea at the time. Discuss your strategy with your account. Property investment should always make sense on a future cash-flow basis. What may seem affordable now is far more expensive over the life of these loans.
With interest rates at record lows it makes perfect sense to pay-down principal debt and interest, to protect your property investment strategy.
There is no guarantee interest rates won’t go even lower, but with the cost of living rising and with the potential for interest rates to do the same, it may pay to reduce the size of your investment loan.
Related Reading: 'Gearing - you don't get 'owt from nowt'
What is an interest-only loan?
Interest-only is exactly that. The borrower is only required to repay the interest component on the loan during the interest-only period, rather than a standard principal and interest loan.
In Australia this type of home loan is typically used to buy an investment property. A standard loan is approved against the principal value of the property and the lender then allows for an interest-only period.
Many lenders allow for an interest-only period of 5 years, with the option to extend for another 5 years. During the interest-only period, the principal debt does not reduce.
Example
You own an investment property worth $440 000 with an interest-only loan of $380 000 at 4.60%. Your weekly repayment is $336. With a principal and interest loan your weekly repayment is $447. That’s an additional $30 000 over 5 years.
Demand for interest-only loans has risen 80% in recent years with 40% all of new home loans written being interest-only.
Why interest-only?
We caution that interest-only loans are not just a tax effective strategy. Interest-only loans may be a tax effective way to invest in property, however, ensure you get the proper advice.
A common goal for using an interest-only loan is using the immediate cost-savings to afford the repayments on a larger investment.
Investors may anticipate at the end of the interest-only period the value of the property will have increased sufficiently, thereby gaining equity without having to pay any of the original principal debt.
Using the example above, an investor would hope their investment property is worth say $490 000 at the end of the interest-only period.
In the meantime, the investor is only willing to maximise the tax deductibility of the interest component and any losses i.e. negative gearing.
Paying down the principal means interest is charged against a smaller loan amount and reduces the dollar amount of the tax deduction.
At the end of the interest-only period, an investor may choose to sell or refinance a property if they can’t afford principal and interest repayments.
There are some compromises
Once the interest-only period has ended the principal debt is amortised over the remaining loan term, potentially ballooning repayments. This has raised the issue of affordability within Government, industry regulators and consumer groups.
A significant disadvantage of interest-only loans is not creating any financial equity in the property, even though significant repayments have been made year after year.
The borrower only makes money if house prices continue to rise in value. However, there is a risk that at the end of the interest-only period, the market has fallen and the property value is not worth as much as the original loan.
Example
If you opt for a 5 year interest-only period on a 25 year loan term, when the interest-only period ends you then have 20 years to pay the principal and interest. If the interest-only period is extended for another 5 years, your principal loan commitments are compressed into only 15 years.
If you are looking to purchase an investment property and an interest-only loan is the only way you can afford it, then this may not be the appropriate choice.
Refinancing to another interest-only loan should not be the alternative.
Interest-only investment loans should only be considered if you know that at the end of the term you will be in a strong position to pay back the principle cost.
Related Reading: 'Lenders Mortgage Insurance - embrace or avoid?'
When it may make sense – do your homework
FACT – Owner-occupied home loans are not tax deductable.
FACT – Investment loans may be tax deductable. Please consult your financial advisor and accountant.
If a couple has both an owner occupied debt or other non-tax deductable house hold expenses like credit cards or car loans for personal use, they may take a short-term strategy to payoff and focus on the higher interest rate loans (like credit cards), then move to their mortgage whilst they continue to service the interest-only payments on their investment loans.
Summary
As with all investments, it pays to understand your future circumstances, your individual risk profile, the key risks involved in property investment and of course always consult with financial and tax experts.
Interest-only home loans can be a tax-effective way to invest in property; however, they are best conducted when the borrower has taken professional advice.
Interest-only home loans should only be considered if at the end of the interest-only term you know you will be able to pay back the principle cost.
Let’s talk
At Loan Avenue we know one size doesn’t fit all. It pays to have a conversation with a real person who wants to hear your story and run through some examples with you.
Why not incorporate a discussion about property investment as part of our free no obligation home loan review?
It’s just one of the many features and benefits included in a tailored home loan from Loan Avenue – affordable home loan solutions for everyday Australians like you.
Let us show you. To make an appointment with one of our experienced and accredited finance professionals call 1300 56 26 28 today or leave a message here.
