Do Interest Only loans make sense anymore?

House on grass

Until earlier this year, interest only loans made a lot of sense!

There was no premium charged on interest rates on interest-only loans over and above principal and interest loans. This allowed them to be used strategically in a number of ways both for investors and future potential investors at no extra cost.

There has been significant pressure from industry regulators for banks to restrict investment lending growth and then, in a second wave of changes, to restrict and reduce interest only lending. Coupled with the banks enduring focus on maximising their own bottom line, the result has been increased costs of interest-only loans. This increase is so substantial that now, for property investors, interest only may no longer be the best option.

Depending on the lender, there is now up to 0.7% difference in the rates for Interest Only (IO) repayments as compared to Principal and Interest (P&I) repayments, or an extra $700 interest per year per $ 100 000 borrowed.

It’s not to say that interest only isn’t still the best option for some investors, but the parameters have changed and re-visiting strategies is a worthwhile exercise.

The potential savings, tax and cash-flow implications of switching from IO to P&I are probably best illustrated with an example.

We’ll use an average investor in the 30% tax bracket, receiving rent of $ 450 per week for a property on which they have $470 000 in debt and use average property expenses of approximately $9000 per year (including body corporate fees, rates, insurance, and property management fees etc).

In summary, by switching to P&I, the investor would:

  • Save $ 2 225 in interest in the first year (savings over 5 years – $ 14 830)
  • Pay additional tax of $667 in the first year ( extra tax over 5 years – $ 4 449)
  • Achieve after tax savings of $ 10 381 over 5 years
  • Pay down their debt by $ 40 000 over 5 years.

The cash-flow cost to the investor of having to pay principal off the loan is partially offset by the saving on interest, but as the saying goes, there’s no such thing as a free lunch! The investor’s first year cash contribution will go from $4514 per year ($87 per week) to $10 147 per year ($195 per week).

It is unfortunately both possible and likely that interest rate for IO loans will continue to increase in the coming months, which may push the cash cost of holding properties on an IO basis up substantially, so it is worthwhile considering the switch.

All of that said, switching to P&I may be a significant adjustment to include in the family budget.

The example above assumes that the investor has refinanced their loans to restart a 30 year term to make the principal and interest repayments easier on their cash flow.  Simply switching an existing loan from IO to P&I over the remaining term (for example 25 years) would have higher principal repayments because of the shorter term. If you’ve had your property for a few years you may need to consider refinancing to extend the term which would soften the blow.

There is no right answer for everyone, but given the extra interest you could now be paying, it’s worth considering the switch.

If you’d like a detailed review of your loans and options, please get in touch. You’ll always know what I think…

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