Many people believe that paying only the interest on an investment property is the best option as it provides more flexibility and cash flow. But, sometimes it can be beneficial for investors to make principal and interest repayments. It all depends on your borrowing capacity, whether you plan to purchase more properties, and what your goals are. For instance, if you prioritise buying more properties, then choosing an interest-only loan might be the right choice for you. However, if you prefer to pay less interest and build equity in your current property, then a principal and interest loan may be more suitable. So, take the time to assess your situation before deciding which type of loan is best for you as an investor.
Loan options: IO or P&I for investors
The key concept is to utilise low-cost lenders with cautious borrowing limits and principal and interest loans to acquire the maximum number of properties permitted.
Once your borrowing limit has been reached, switch your loans to interest-only and seek out lenders that allow you to borrow more, although their rates may be slightly higher, in order to finance new properties.
Before we dive deeper, let's take a moment to discuss the primary distinction between an interest-only loan and a principal and interest loan.
Interest-only loans (IO)
- With an interest-only loan, you are solely responsible for paying the interest on the loan. Your original loan balance, known as the principal, remains unchanged.
- Typically, interest-only repayments are set for a designated period, usually around 5 years. However, certain lenders may offer an interest-only period of up to 10 to 15 years.
- At the end of the interest-only period, you have the option to extend the loan's interest-only term or refinance to continue the interest-only period.
Principal and interest (P&I) loans
- With a principal and interest loan, you are responsible for making repayments on both the interest and a portion of the principal. As your repayments are greater than the interest charge, you gradually reduce the loan balance with each payment.
- It's important to note that only the interest portion of the loan is tax-deductible for investors. The principal portion, which goes towards reducing the loan balance, is not eligible for tax deduction.
How interest rates might affect your decision
It's worth noting that interest-only (IO) loans typically have a higher interest rate. This is particularly true for investment loans, which generally have higher rates compared to owner-occupied loans. As a result, interest-only investment loans tend to have an even higher rate than other types of loans.
According to data from June 2020 based on advertised rates from the Big Four banks, the average interest rate for IO investment loans was 0.31% higher than that of principal and interest investment loans.
Example: How much interest you'll pay
To better understand how the two loan types differ, let's consider Tim’s situation. He is seeking a loan of $500,000 and is currently contemplating whether to opt for an interest-only or principal and interest loan for his investment property.
If he chooses an interest-only loan, his repayments will consist solely of the interest charged on the $500,000 loan. On the other hand, if he opts for a principal and interest loan, his repayments will include both the interest charges and a portion of the principal balance.
As a result, Tim's repayments for the interest-only loan will be lower than those for the principal and interest loan. However, it's important to note that he will not be paying off any of the principal balance with each repayment, which means that he won't be building equity in the property.
On the other hand, with a principal and interest loan, Tim will gradually pay down the principal balance with each repayment, which will increase his equity in the property. While his repayments will be higher than those for an interest-only loan, he will be reducing his debt and building equity in his investment property over time.
Investment loan: Principal & interest
Interest rate: 4.09% p.a.
Loan term: 30 years
Monthly repayments during IO period (5yrs): Not Applicable
Monthly principal and interest repayment: $2,413 p.m.
Total interest payable: $368,713
Additional interest payable: $0
Investment loan: Interest-only (for 5 years)
Interest rate: 4.34% p.a.
Loan term: 30 years (5-years IO)
Monthly repayments during IO period (5yrs): $1,808 p.m.
Monthly principal and interest repayment: $2,664* p.m.
Total interest payable: $407,728
Additional interest payable: $39,015
*Based on the assumption that the variable rate converts to 4.09% once IO term expires.
Using an interest-only (IO) loan can give you more cash flow during the IO period because you're only paying the interest charges. However, this means you'll end up paying more interest in the long run.
For example, let's say Tim is deciding between a $500,000 IO vs principal and interest loan for an investment property. Over the life of the loan, Tim would pay $39,015 more in interest with an IO loan. On the other hand, Tim would have an additional cash flow of $7,257.08 per year for a total of $36,235 in five years due to the IO period. Tim can use this extra cash flow to invest in more properties or choose a P&I loan if his goal is to pay less interest. To get a detailed breakdown of your cash flow, interest expense and tax deductions over the life of your mortgage, you can use our IO vs P&I calculator.
How does Interest Only and Principal and interest affect your borrowing power?
It's important to note that borrowing power can vary between lenders, and it's always a good idea to speak with a mortgage broker or financial advisor to understand your individual circumstances and options.
In general, if your goal is to maximise your borrowing power, it may be worth considering a combination of both IO and P&I loans, depending on the lender and their assessment criteria. However, it's important to also consider the potential impact on your long-term financial goals and interest expenses.
Actual Repayments vs Assessment Rate: Borrowing power example
Let's imagine that Tim is interested in purchasing an investment property, and he currently earns $90,000 per year before taxes. To determine how much he can borrow, we consider his current situation: he's single with no dependents or liabilities.
If Tim takes out a 30-year loan on the property with a 5-year interest-only period and works with a lender who uses a floor assessment rate (in this case, 5.40% per annum), his maximum borrowing power will be $599,707.
However, if Tim works with a lender who assesses his actual repayments instead, he may be able to borrow up to $704,000 for the same loan at a lower interest rate of 4.34% per annum. That's a difference of $104,293 in borrowing power, and it's worth noting that this calculation does not take negative gearing benefits into account for simplicity.
Optimising tax deductions through Interest Only and Principal and interest loans
When you have investment properties, you can deduct the interest paid on loans from your taxes. This means that with an interest-only loan, you can claim a tax deduction for all the payments made during the IO period. However, if you have a P&I loan, only the interest portion is tax-deductible, not the principal portion. For instance, if you're making P&I repayments on a $500,000 loan, in the first year, you would have paid $16,849 in interest and $9,760 in principal. Here, only the interest portion of $16,849 is tax-deductible.
Example: Principal and interest Amortisation schedule
Let's use an example to make things clearer. Say you take out a loan of $500,000 with a 4.09% p.a. interest rate and opt for principal and interest repayments. In the first year, you will have paid $16,848.84 in interest and $9,760.08 in principal. While the interest portion is tax-deductible, the principal repayment is not. This trend continues over the next 4 years, with a total of $80,755.12 paid in interest and $52,289.48 paid in principal by the end of year 5.
It's important to keep in mind that if you choose an interest-only loan, all your payments during the IO period are tax-deductible, while with a P&I loan, only the interest portion is tax-deductible. Your choice of loan structure ultimately depends on your goals, whether it's buying more properties or paying less interest, and your unique financial situation.
Key points for property investors
- Using a multi-lender mortgage strategy can be a smart move. This involves using conservative lenders with P&I loans to purchase as many properties as possible within your borrowing power. Once you reach your limit, switch to interest-only loans and seek out lenders who allow for higher borrowing power, even if their interest rates are slightly higher.
- To minimise your bad debt, pay off your most expensive loans first, such as credit cards and personal loans. Your home loan may still be more expensive than investment loans, even with a lower interest rate, since it's not tax-deductible.
- If you opt for an IO loan, create an exit strategy before the IO period ends. Many lenders require a new assessment for IO extensions, so consult with a mortgage broker to create a realistic plan for the future.
- When your compare interest rates, fixed-rate loans are often cheaper than variable loans for investment purposes. However, it's always wise to weigh both options.
- If you're planning to convert your home into an investment property down the line, you can save on taxes by placing extra repayments into your offset account instead of paying down your home loan balance.
Do you need help deciding which loan type is best for you?
Deciding between a principal and interest or interest-only loan depends on your specific financial situation and goals. If you're unsure which option is best for you, consider speaking to a mortgage broker for personalised advice.
Our team of mortgage brokers can assist you in determining which loan option is right for you. Whether you prefer to call us on 1300 799 702 or book in a Discover Call, we're here to help.
