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There are a lot of decisions that lead to a successful property investment, one of the most important being what type of investment property loan an investor should choose.
The loan repayment scheme you choose significantly affects the cost, cash flow, and overall finance structure of your investment property.
When choosing an investment property loan, here are some things you need to know:
What is the difference between principal and interest?
A loan is composed of the principal amount and interest.
The principal amount is the amount you borrowed from the lender.
Meanwhile, the interest is the amount charged by a lender for borrowing principal. Interest is calculated using the loan’s interest rate, usually expressed as an annual percentage.
The higher the interest rate, the more you pay on top of your principal borrowed amount.
When making repayments on the loan, investors usually have two options: pay towards the principal amount with interest or only pay interest without chipping off the principal (for a limited time).
Interest-only (IO) investment loans
As the name suggests, an interest-only loan means your repayment covers the interest and does not include the principal amount. The interest-only period doesn’t last forever, though. It’s usually between one and five years, after which the loan reverts to principal and interest repayments.
Advantages of an interest-only loan
The main advantage of an interest-only loan comes in lower repayment amounts. Since you’re not paying down the principal of the loan, you could have more money left over every month.
This could be great for investors who want to manage cash flow better, put money towards improving the property or manage periods of tenant vacancy.
Depending on the circumstances, you may also be able to claim tax deductions on interest paid on an interest-only loan. It’s best to consult with an accountant or financial advisor to know if you’d qualify for certain tax benefits.
Disadvantages of an interest-only loan
Making interest-only payments could increase total interest paid over the life of the loan. Since you’re not deducting the principal balance, the interest calculated against your loan remains the same throughout the interest-only period.
You could have limited equity with an interest-only loan, as well. Equity is the value of the property minus the loan balance. If the property value doesn’t increase in the interest-only period, your equity could remain stagnant as well.
Principal & interest (P&I) investment loans
With a principal and interest loan, your repayments will go towards the amount you borrowed and the interest charged. Every repayment will reduce the principal amount. A typical principal and interest loan has a term of up to 30 years.
Advantages of a principal & interest loan
Because you’re paying off the principal amount owed and interest at the same time, you could reduce the total interest paid and build equity more quickly.
The less principal amount you owe, the less interest you could potentially pay overall.
If you’re chipping away at the principal amount, you’re also building equity as you owe less and, potentially, the property’s value increases.
This is ideal for those who want to prioritise paying off their loan sooner so they can own their property outright.
Disadvantages of a principal & interest loan
A principal and interest investment loan does usually have a higher repayment amount compared to an interest-only loan. This may be a setback for investors who want to free up more cash flow.
Principal & interest loans vs interest-only loans
Here’s a quick overview of the differences between two loans paying interest only and principal and interest:
|
|
Interest-Only Loan |
Principal & Interest Loan |
|
Loan term |
1 to 5 years (after which the loan will revert to a principal and interest loan) |
Up to 30 years |
|
Repayment amount |
Lower since it does not include the principal amount (during the interest-only period) |
Higher compared to an interest-only loan as it includes the principal amount owed plus interest charges |
|
Interest rate |
Typically higher compared to principal and interest loans |
Typically lower compared to interest-only loans |
|
Advantages |
Lower initial repayments, more cash flow, potential tax incentives for investors |
Lower interest paid overall, could build equity much more quickly |
|
Disadvantages |
Higher interest paid over the life of the loan, reduced ability to build equity |
Higher initial repayments, less cash flow |
Choosing an investment home loan
Each investment loan option has its pros and cons. It’s up to investors to decide which one fits their needs best and can help them achieve their investment goals. If you’d like to know more about investment home loans, get in touch with the lending specialists at loans.com.au today! Call 13 10 90 or pre-qualify online.
Disclaimer: The information provided in this article is general in nature and does not constitute financial or legal advice. Please seek professional advice tailored to your personal circumstances before making any financial decisions.
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