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Most property investors use interest-only loans to finance their properties, but never stop to think about what happens when the interest-only period comes to end.
With a traditional home loan, each repayment will be made up of interest as well as principal.
The repayment amount will be calculated in a way so that your loan balance reduces over time, and will be equal to zero at the end of your loan term.
As the name suggests, with an interest-only mortgage your repayments only cover the interest on the amount you have borrowed, during the interest-only period which means your repayments are lower than with an equivalent principal and interest loan.
By only paying the interest, your loan balance will remain the same and will not reduce like a normal home loan.
In most cases, the interest-only period for a loan will be limited to five or ten years, after which time the loan will automatically switch to a principal and interest loan with a corresponding increase in repayments.
The jump in repayments can catch many investors off-guard, particularly as repayments are calculated based on the remaining term of the loan.
For instance, if you took out a 30-year loan and paid only interest for the first 10 years, the repayments (once the loan switched) would be based on paying back the loan in just 20 years.
It’s worth noting that the adjusted repayments would be higher than if you had started paying principal and interest at the start of the loan.
Interest Only Loans Benefits
For example, you may only be able to afford full repayments (Principle and Interest) on two standard loans but could afford interest only repayments on three loans.
Another benefit for property investors is the ability to maintain the maximum tax deduction.
Interest payments on investment properties are tax-deductible, however, any principal repayments are not tax-deductible.
By not repaying principal (the loan balances never reduces), you will always be able to claim the maximum tax deduction on your loans.
This allows you to put more cash into paying down non-deductible debt or into other assets.
Using an offset account on an interest-only loan
Smart investors use any spare cash to make extra payments into an offset account to reduce the amount of interest they pay on their loan.
This has the same effect as paying principal and interest loan but you remain in control of your money.
Having a $500,000 mortgage and $100,000 in your offset account is the same as having a $400,000 mortgage but you can always redraw your money without asking the bank for permission.
The risks of interest-only loans
1. The extra interest you’ll pay on an interest-only loan
During the interest-only period, as you do not reduce the amount of money you owe, you’ll end up paying a lot more interest over the life of the loan, compared to a principal and interest loan.
For example, with a $500,000, 25-year loan, with an interest rate of 5%, a person would pay $40,062 more in interest with an interest-only loan compared to a comparable principal and interest loan.
2. Your property does not increase in value.
What are your options when your lender notifies you that your interest-only period is expiring?
Firstly, you can do nothing and simply start paying off the loan.
This is probably the simplest option as you don’t need to do anything but increase the repayments you make each month.
But if you don’t want to do this, you could ask your lender to extend the period.
Depending on your lender, this may or may not be an option.
When the market is competitive and lenders are hungry for business, you’ll find that most will try to keep their customers happy, but currently, APRA is restricting the percentage of interest-only loans lenders are giving to property investors.
Another option is to refinance the loan with another lender, which, as well as providing a new interest-only period, could save you money.
As always it’s best to consult an investment savvy mortgage broker before doing anything.
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