Which loan strategy is best for property investors?
What’s better for property investors – paying interest only or principal & interest repayments on their loans?
As you can guess, there’s not one correct answer, but let’s explore the options…
Interest only loans
With interest only (IO) loans you are only required to repay the interest on your loan (plus any fees) over the IO period.
Usually on expiry of the original IO period (which is often 5 years but can be up to 10 years), the bank usually requires you to start paying back a portion of the principal (the loan balance.)
But you can request a new IO term if you wish. But be warned – the bank don’t always accept these requests.
Principal & interest loans
Principal & Interest (P&I) loans are designed to repay your loan over the defined loan period – usually 30 years.
Your lender calculates your repayments which include the interest charged for the repayment period and any loan fees, plus a portion of the principal balance which slowly gets paid down.
Early in the term of your loan you’ll find your monthly payments are mainly paying interest and very little goes towards repaying the loan balance. Over time as your loan balance reduces, so does the interest component, meaning your regular repayments pay off more of the loan principal.
Using Interest Only loans
IO loans are popular with property investors because repayments are lower – you’re only paying interest and not repaying the loan principal. This obviously frees up cash flow.
Of course the underlying assumption using this strategy is that your investment property is going to increase in value so over time your loan to value ratio decreases.
Lower repayments may also allow you to:
- Pay off other non-deductible personal debts such as your home loan, credit cards or car or personal loans
- Save the deposit for your next property purchase.
- Pay more than the minimum required amounts or deposit them in an offset account – leaving you a “rainy day financial buffer” or
- Pay off a portion of your principal.
Using Principal and Interest loans
I know some investors prefer P&I loans as they see them as a form of forced savings.
This works particularly well for non-tax deductible debt like your home loan and are even better if your loan has a redraw option giving you access to any funds available in your loan account.
So which is better?
Getting the decision right is clearly important and as I don’t know your particular circumstances, my best advice is to seek professional advice when planning your finances.
However if you are still at the asset accumulation stage of your property investment journey, you’ll probably appreciate the lower repayments offered by IO loans as this should make servicing your loan easier.