Interest Only Loans
For decades, Australian property investors have relied on Interest Only loans. What is an Interest Only loan, and why have they been the preference for investors?
Loans usually have two repayment options, Principal and Interest (P&I), or Interest Only (IO). P&I repayments are calculated to ensure that you pay off the loan balance (principal) as well as the interest incurred each month so that you pay the loan to zero by the end of the loan term, usually 30 years.
Interest Only repayments, however, may generally be chosen for a period of 1-5 years. During this period, the principal does not reduce at all, as you only pay the interest incurred.
Let’s say you have a 30 year term, and a 5 year interest only term. For the first 5 years you will only pay the interest each month. Once that finishes, you are expected to pay the principal and interest over the remaining 25 years. Although many property investors have continued to refinance to extend the IO period when it expires, effectively remaining on IO terms for longer.
This has been a common property portfolio growth strategy because the principal portion of P&I repayments is not tax deductible, whereas the interest is. By maintaining a higher loan balance, investors have been maintaining a higher tax deduction and reducing their cashflow output.
Using this strategy, investors can use an Offset account to build additional savings which can then be used towards future property purchases.
In 2024, is this strategy still relevant?
Firstly, interest only loans now have higher interest rates than principal and interest. This certainly can negate some of the benefit. Check out this speech from the RBA’s Assistant Governor in 2017 which explains how that came to be.
Secondly, prior to the abovementioned changes, servicing was calculated on the IO payments and did not factor in the higher P&I repayments. As a result of Responsible Lending implications, lenders now have to calculate your capacity to repay the loan at P&I repayments over the remaining term, reducing your maximum loan amount.
Finally, this strategy relies heavily on market growth. Australian property prices have boomed in the last 5 years, but is that sustainable? Can we expect it to continue in the future?
The risk is that property prices stagnate (or worse = decline), and you find yourself in a position with no more equity (or worse = negative equity). This can impact your future plans to grow your portfolio.
When the 5 year term expires, you will be faced with higher repayments or the need to refinance to extend the IO period. If your financial position changes, or your borrowing capacity decreases due to external factors like policy or increased interest rates, the option to refinance to extend may not be available.
Key Considerations for Interest Only Strategy
- Do you understand and accept the risks with this strategy?
- Do you want to pay a higher interest rate?
- Do you have the capacity and discipline to build savings in an offset?
- Do you want to leave the equity increase in the hands of the property market?
- Would you benefit from financial planning advice regarding the strategy?
Alternative to Interest Only Strategy
The alternative strategy to Interest Only repayments is to use Principal and Interest repayments to reduce the loan, therefore building equity in a controlled manner, and then using the equity to invest further. The interest portion of your repayments remains tax deductible, and your loan is steadily decreasing with the end game of passive income.
Let’s do a side-by-side comparison.
Assume a property purchase of $500,000 and a loan amount of $400,000 to give us a nice tidy 80% LVR. We’ll assume market growth of 5% per year.
P&I | IO | Difference | |
Interest rate | 6.3% | 6.55% | 0.25% |
Repayment | $2,474 | $2,180 | -$294 |
Equity after 5 Yrs | $264,570 | $238,140 | $26,430 |
Interest payable 30 Yrs | $490,382 | $544,050 | $53,668 |
In this example, while your monthly repayment is almost $300 less for Interest Only, you pay considerably more interest over the life of the loan.
As is the case with these strategies, they will suit some investors more than others. The most important thing is that you understand the pros and cons of the Interest Only strategy and how it fits within your unique financial position.
