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When you’re buying an investment property, you may need to consider a different type of loan than the one on your owner-occupied property.
Here’s what to consider when comparing investment loans to maximise your cash flow goals.
What are your investment loan options?
There are two main loan options: an interest-only loan or a principal and interest loan. You can also choose from a fixed or variable loan.
Interest-only investment loan
An interest-only (IO) loan is a home loan where borrowers are only required to pay off the interest portion of the loan for an agreed period of time, generally between one and five years. At the end of that set period, the repayments will transition to principal and interest (P&I) repayments.
Pros of interest-only loans
- Lower repayments: As you’re only paying off the interest portion of the loan, the temporary lower repayments can free up cash for other expenses like renovations or purchasing another property.
- Tax incentives for investors: Interest-only loans are popular with investors who plan on making a profit by selling their property within the IO period (eg. after making a capital gain) as it reduces their expenses.
Cons of interest-only loans
- Repayment shock upon expiry: The expiry of the interest-only period can come as a shock if you’re not prepared as the costs of repayments suddenly increase.
- Generally higher interest rates: Interest-only loans generally have higher interest rates than principal and interest (P&I) loans, however, this isn’t always the case depending on the lender.
- Higher interest costs overall: As you’re not paying off the principal (the amount borrowed) during the interest-only term, you’ll end up paying more interest over the life of the loan than someone who has been paying both principal and interest over the entirety of their loan term.
- Less equity: By only paying off the interest portion of the loan, you’re not building up any equity in the property. This can depend on what the property market is doing - some investors have built equity in the value of their properties thanks to property price increases.
Principal and interest investment loan
Principal and interest (P&I) loans are where the borrowers make contributions towards the principal (the amount borrowed) while also paying off the interest portion of the loan.
Pros of principal and interest loans
- Paying off the value of the property: Unlike interest-only loans, borrowers are paying off the amount borrowed, so the actual house you’ve borrowed all that cash for is being slowly paid off.
- Building equity: Because you’re paying off the amount borrowed, you’re slowly building up equity in the property, helping you own the asset sooner.
- Generally lower interest rates: P&I home loans generally have lower interest rates than IO loans, though this can depend on the lender.
- Pay less interest overall: As you’re paying off the principal amount plus interest, you’ll pay less interest over the life of the loan than someone on interest-only repayments.
Cons of principal and interest loans
- Higher repayments: Repayment amounts are higher with P&I loans as you’re paying off the amount borrowed plus the interest portion of the loan.
Fixed vs variable rates
A fixed interest rate can be a great product for investors who want more certainty about their outgoing costs and want to make budgeting as easy as possible. Fixed rates allow investors to match their loan term to the length of time they anticipate owning the property. However, fixed-rate loans aren’t as flexible as variable rate products, don’t offer the same features, and usually don’t allow extra repayments. Breaking a fixed rate term early also incurs break costs.
Variable rates fluctuate over time according to cash rate movements and other factors, which means monthly repayments will also vary. A variable interest rate may suit investors who aren’t as concerned about repayment fluctuations and have a high level of awareness about how their cash flow levels may be impacted by rate falls or rises. Variable rate packages also generally offer extra features that fixed products don’t, such as offset accounts, redraw facilities, the ability to make additional repayments, loan splits, and so on. These features can allow investors to make the most of their investments.
Why are interest-only loans so popular with investors?
Many investors favour interest-only loans because they can claim a portion of their loan as an investment expense on their tax returns.
According to the ATO, “If you take out a loan to purchase a rental property, you can claim the interest charged on that loan, or a portion of the interest, as a deduction. However, the property must be rented, or genuinely available for rent, in the income year for which you claim a deduction.”
There are some caveats to this rule but essentially, this means that investors can claim their entire mortgage repayments during the interest-only period as a tax deduction. The higher the loan balance and longer the IO period, the more an investor can maximise their tax-deductible benefits.