Investment Properties - Should You Have an Interest-Only or Principal and Interest Loan?
This is a common question for property investors, and one where the choice is becoming increasingly difficult!
First let’s quickly define these two terms:
Interest-Only Loan (I/O): You only have to make interest payments on the outstanding mortgage amount (for a certain period of time, typically 5 years, after which the loan will be converted back to P+I, or refinanced for another I/O term).
Principal and Interest Loan (P+I): You have to make payments off the principal loan amount, in addition to the interest payments. As the loan progresses, you pay proportionally higher principal, and less interest.
As an example, if you have a 30 year, $500k loan at 4% p.a. interest :
Amount payable with I/O - $20,000 per year
Amount payable with P+I - $28,650 per year
Repayments are obviously higher with P+I, however this does mean you are paying off your balance and therefore your total interest payment over the life of the loan will be lower.
Interest-only loans have been heavily favoured by investors over the last decade or two for a couple of reasons:
- Lower monthly repayments (improved cashflow) which frees up cash for use elsewhere (other investments, living expenses)
- Allows maximum tax deductions (as you are always paying interest on the full balance of the loan)
- Flexibility with extra funds (by using offset accounts)
However in recent times, due to concerns for the levels of household debt, relevant authorities such as APRA have placed restrictions on new I/O loans. This has resulted in a premium on I/O home loans which now have a significantly higher rate than P+I loans. In addition, when current I/O loans expire and the loans are converted to P+I, there may be a large increase in repayments for those who cannot re-finance for a new I/O term.
In some cases it is currently possible to get a 1% discount for P+I on your investment property loan, meaning it may make more sense to consider this option. Let’s look at (more realistic) example with a higher I/O rate:
A) 30 year, $500k loan with 5% I/O rate – annual repayment = $25,000.
Principal Paid = $0
B) 30 year, $500k loan with 4% P+I rate – annual repayment = $28,650
Principal Paid = $8,650.
So while overall you are paying slightly more per year with P+I ($3,650), you are paying $8,650 off your principal. This is a great return on investment, as you are getting a 236% return on your extra payment! The alternative is paying an extra $5,000 in interest to the bank – this isn’t worth it for the tax benefits! In addition, you will be looked upon more favourably by lenders when you are actively taking steps to pay down your debt using P+I, while building equity in your investment property. This is my preferred option for investors in the current market.
First let’s quickly define these two terms:
Interest-Only Loan (I/O): You only have to make interest payments on the outstanding mortgage amount (for a certain period of time, typically 5 years, after which the loan will be converted back to P+I, or refinanced for another I/O term).
Principal and Interest Loan (P+I): You have to make payments off the principal loan amount, in addition to the interest payments. As the loan progresses, you pay proportionally higher principal, and less interest.
As an example, if you have a 30 year, $500k loan at 4% p.a. interest :
Amount payable with I/O - $20,000 per year
Amount payable with P+I - $28,650 per year
Repayments are obviously higher with P+I, however this does mean you are paying off your balance and therefore your total interest payment over the life of the loan will be lower.
Interest-only loans have been heavily favoured by investors over the last decade or two for a couple of reasons:
- Lower monthly repayments (improved cashflow) which frees up cash for use elsewhere (other investments, living expenses)
- Allows maximum tax deductions (as you are always paying interest on the full balance of the loan)
- Flexibility with extra funds (by using offset accounts)
However in recent times, due to concerns for the levels of household debt, relevant authorities such as APRA have placed restrictions on new I/O loans. This has resulted in a premium on I/O home loans which now have a significantly higher rate than P+I loans. In addition, when current I/O loans expire and the loans are converted to P+I, there may be a large increase in repayments for those who cannot re-finance for a new I/O term.
In some cases it is currently possible to get a 1% discount for P+I on your investment property loan, meaning it may make more sense to consider this option. Let’s look at (more realistic) example with a higher I/O rate:
A) 30 year, $500k loan with 5% I/O rate – annual repayment = $25,000.
Principal Paid = $0
B) 30 year, $500k loan with 4% P+I rate – annual repayment = $28,650
Principal Paid = $8,650.
So while overall you are paying slightly more per year with P+I ($3,650), you are paying $8,650 off your principal. This is a great return on investment, as you are getting a 236% return on your extra payment! The alternative is paying an extra $5,000 in interest to the bank – this isn’t worth it for the tax benefits! In addition, you will be looked upon more favourably by lenders when you are actively taking steps to pay down your debt using P+I, while building equity in your investment property. This is my preferred option for investors in the current market.
If you want to get in touch, please send me an email:
micahkg@gmail.com
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