We often talk about the importance of paying down your loan faster to save money. But there are also situations where it makes sense to repay your loan at a slower pace. With an interest-only loan, you pay off just the interest on the amount you've borrowed. After an agreed period, the loan reverts to principal and interest repayments, causing your repayments to jump up. It’s only from here that your debt will begin to reduce. And because you're not paying off the principal from the start, the interest bill over the life of the loan will be higher.
Here we look at some common scenarios and the type of loan structure that might work best.
You're a well-informed investor making high growth investments
An interest-only loan could work well here if you're organised and have a well-structured investment plan. Interest-only repayments can maximise cash flow, freeing up funds to buy your second investment property. Using a high-growth investment strategy, you buy properties with a strong chance of capital growth and sell when their value increases. Whether you sell within a few years or wait for over ten years, the goal is to make a profit at sale time.
It’s vital to be a well-informed investor for this loan structure to work because you need to be aware of the risks. An obvious risk is that you might be tempted to borrow more than you can afford. Another risk is that your choice of property is unsuitable, and its value never increases enough to turn a profit. If the property loses value before you have even paid off any of the principal, you could end up owing more than it is worth. If you want to build equity without relying on capital growth, an interest and principal loan is considered a safer choice.
You're a well-informed investor hoping for a tax break
As a property investor, you’re entitled to claim a tax deduction for the interest paid on your home loan, or at least a portion of it. The property must be rented or genuinely available for rental, in the same income year as the deduction you’re claiming. With an interest-only loan, you can prioritise paying down your owner-occupied property, which is non-tax deductible.
For ongoing interest savings, open an offset account linked to your mortgage and put extra repayments into here. An offset account reduces the balance in your loan account by whatever the balance in the offset account is. By reducing the principal, you also reduce the interest charged
You need to make limited home loan repayments for a few years
An interest-only loan is sometimes used by borrowers who might need to take a break from earning an income, such as to become a carer. Or by first-home buyers who need to spend a few years saving to recover from the set-up costs of buying a home. For this loan structure to succeed, it’s vital to plan for how to make full repayments once the interest-only period finishes.
You’re buying a home to live in yourself
Interest rates on principal and interest loans are often lower than on standard loans. As an owner-occupier, it makes financial sense to prioritise paying down your mortgage as quickly as possible with a principal and interest loan. With historically low-interest rates, you can get working right away on paying off the principal amount. If rates rise in the future, you will have lessened the impact by reducing your loan size.
Talk through the pros and cons of what works best with your local Yellow Brick Road mortgage broker. We’ll explain the subtleties of these loan structures as they relate to your needs and financial situation.