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When buying a residential property, you have the option of selecting the repayment method based on your personal circumstances. The loan may be paid as an “Interest-only” loan or “Principal & Interest” loan.
Under the “Interest-only” option, as the name suggests, only the loan interest is being paid while principal of the loan remains the same. Usually, “Interest-only” period (“period where only the interest is paid and then converted to a “Principal & Interest”) is generally restricted to a maximum of 5 years. Amidst recent regulatory pressure, the bank has temporarily suspended “Interest-only” loans for the primary residence and still lending against investment properties at a higher rate than a principal and interest rate.
The reason behind the “Interest-only” loan is the ability to pay a lower loan repayment as opposed to the “Principal & Interest” option. In an investment property scenario, the tax deduction over the time may be higher as the interest payable over the time is higher for the “Interest-only” loans. This approach is not recommended for everyone.
There are myrid risks involved in the “Interest-only” Loans as opposed to the other. One would need a careful consideration when selecting an “Interest-only” or “Principal & Interest” option of a residential property loan.
Lower cash flow
For an example, for a residential property loan of $500,000, the weekly repayment under the “Interest-only” will be $ 432 (at 4.5%* per annum) and the repayment under the “Principal & Interest”option, will be $ 550 (at 4.5%* per annum). This saves $ 118 per week if the “Interest-only” option is selected. In spite of a higher interest rate, your repayment will be lower in an “Interest-only” loan.
Saving cash from the investment property and paying off the living in property faster
It is a wise approach to proceed with the “Interest-only” option for your investment property and use the cash flow savings to pay off the home loan of the primary residence. Remember, from tax perspective, you can claim interest expense of an investment property loan.
Higher Tax Deductions
The estimation of the tax deduction is simple for the “Interest-only” loans since the entire payment is identified as an interest payment. If the loan is a “Principal & Interest”, it is complex to estimate the interest portion to claim the tax deduction.
If the “Principal & Interest” option is selected, the interest payment diminishes over the time and followed by diminishing tax deductions. Therefore, an investment property owner may derive a higher tax deduction under the “Interest-only” loan if the strategy is in place.
Detrimental in a declining market
The main risk in this approach emerges If the property falls in value. The investor will have a loan which exceeds the property value as the loan is being not paid over the time.
Higher Interest Rate
With recent regulatory pressure by ASIC, the interest rate charged for a “Interest-only” have soared by approximately 0.5%*. This results, the interest cost of the loan is higher despite the fact that your cash flow is lower in an “Interest-only” loan compared to the other.
In the above example, the interest cost of 4.5%* – “Interest-only” loan for 5 years is $ 112,500 whereas $ 96,288 if “Principal & Interest” loan is selected at 4.0%* per annum. In this aspect, one pays an additional interest of $ 16,212 (within 5 years) to save the short term cash flow.
Less Borrowing Capacity
When evaluating an application for an “Interest-only” loan, the lender require more income capacity to repay the loan compared to a “Principal and Interest” Loan.
Who could benefit from Interest Only Option
The “Interest-Only” loan is useful for property investors who can claim the interest as a tax deduction and first home buyers trying to make their first year in their new home more affordable, or buyers who only plan on holding onto the property for a few years before selling it.
Comparison using the Example
The comparison table below may provide some valuable insights into the cash flow and Interest payments under two different options;
Figures included in this example are estimates only.
Example: “Interest-only”$ 500,000 loan at 4.5% and the interest only period is for 5 years assuming the loan interest will be 4.0% after the first five years vs “Interest & Principal” Loan of $ 500,000 at 4.0% *
“Interest-Only” Loan “Principal & Interest” Loan
within first 5 years $ 432.69 $ 556.06
after first 5 years $ 615.50 $ 556.06
Interest cost for 30 years $ 367,451 $ 489,013
As illustrated above, the interest savings of the second option is $121,562
How Rands Financial Services can help our clients
With interest rates at their lowest for more than 50 years, there are some great rates available. Rands Financial Services is not only a Mortgage Broker but an Accountant too.
We help our clients to choose the best loan product with correct features to suit the circumstances.
* per annum rates
Disclaimer: The views provided here are of a general nature only and should not be taken as financial advice. Please speak to a qualified professional before making any financial decision.