Should you choose an interest-only loan for your investment property?

By YIP | 29 Sep 2021

If you’re tossing up between an interest-only or principal and interest loan for your investment property, you’re probably already knee-deep in research. We explore some of the benefits and reasons why investors use interest-only loans to help you decide.

An interest-only loan is a loan that only requires you to pay off the interest portion of the loan for a set period of time, usually up to five years before the loan reverts to a principal and interest loan.

Interest-only loans are popular with investors who want to maximise their cash flow while keeping expenses low. But is an interest-only loan right for you and your investing strategy?

Benefits of interest-only loans

Your repayments are lower

Because you’re not paying off any of the debt on the property, your loan repayment amounts are lower as you’re only paying off the interest portion of the loan. This is arguably the biggest pro of an interest-only loan and one of the main reasons why investors opt for this kind of loan as it gives them repayment certainty for the first few years when trying to find tenants and minimise other starting costs.

Interest-only repayments also allow investors to maximise their cash flow by freeing up the principal amount of each repayment for other uses, such as to save a deposit for their next property purchase or pay off debts.

"Recently we've seen a number of our customers opting for principal and interest due to lower rates being available. That being said, increasingly our investment customers have been opting for interest-only to manage their cash flow, and renovating particularly during these lockdown periods,” Marie Mortimer, Managing Director (pictured) said.

Image supplied.

“We're noticing in general people are using their funds and additional cash flow to renovate and complete cosmetic upgrades to their kitchen or bathrooms, to add value to their property.”

It’s important to remember that all good things must come to an end and after your IO period expires (usually after a maximum of five years) your repayments will increase as you begin paying off the principal portion (the amount you’ve borrowed).

Tax benefits

Because you’re not paying off the principal amount during the interest-only period, the entire interest amount can be claimed as a deduction against your income.

Some investors choose to maximise their interest repayments and use the tax-deductibility of interest on their loan repayments. In some cases, you can choose to pay the interest annually in advance to reduce your taxable income.

Why choose an interest-only loan for your investment property?

An interest-only loan means that the rent will cover most, if not all of your monthly mortgage repayments. This means that you can direct any extra cash towards other things, like saving for your next investment property purchase, renovations, or to pay off other debts. While these cheaper repayments may only last for a few years, those savings in the first few years of the mortgage can really pay off if you’re trying to keep your initial expenses low and maximise cash flow.

Interest-only loans are useful for tax purposes too. Any interest accrued on the interest portion of the loan is tax deductible. If you’re only making interest repayments, you can claim the entire payment in your personal tax return.

Many investors choose interest-only loans because they don’t intend to hold onto the property for very long and are relying on capital growth to build equity in the property. This is known as a compound growth strategy.

Assuming the value of the property increases enough during the interest-only period, an investor can sell it, pay off the principal and still make a profit. But if the value of the property doesn’t rise or goes down during the interest-only period, you could end up owing more on the loan than what the property is worth - known as negative equity.

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