All home loan repayments include interest due on the amount borrowed. The repayments will either be principal and interest (P & I) loan—where part of your repayment also goes towards reducing your balance— or an interest only (IO) loan, you only pay the interest. The riskier nature of IO home loans makes lenders offer for a limited terms (usually up to five years) after which the loan is automatically converted to a P & I loan.
IO home loans predominantly benefit investors and are not recommended for owner occupiers because they do not allow you to build equity in your property. Under Australian tax law, interest repayments on property investments are tax deductible. An IO home loan can help an investor maximise their investment strategy, tax advantages and cash-flow.
How interest only loans work?
If you start your home loan with an IO period, you can expect initial repayments to be lower. That said, IO interest rates tend to be higher than P & I interest rates. In the long term, an initial IO period will have made your home loan more expensive because you will have paid more interest over the term of your loan than if you had started out with a P & I home loan.
At the end of the IO period, your repayments will increase to cover both the principal and the interest. What is more, the reduced period to pay off the principal, substantially increases your repayment.
Illustration:
With a normal P & I Loan for $500,000 at 4.78% p.a. based on an LVR of 80% over 25 years, the total cost of interest on the loan would be $357,766 over the 25-year period.
For the same loan with an IO period of 10 years, the total cost of interest on the loan would be $440,443 over the 25-year period and therefore would cost you an additional $82,676 in interest compared to a loan that had P & I repayments over the full 25-year term.
Benefits of an interest only loan
Smaller repayments
During the IO period of the home loan, monthly repayments will be lower compared to a P & I loan.
Improved cash-flow
Lower repayments mean you could use your cash for other purposes that may be financially beneficial like paying off debts, making other investments or funding a loan to purchase another property.
Maximise tax benefits for property investors
The interest on a loan to purchase an investment property is tax deductible.
Benefits are ongoing for the life of the IO term
You can often choose an IO term of one, three, five or 10 years. This can be very beneficial for tax minimisation strategies and financial planning purposes. Please speak to your accountant to find out how to make it work for you.
Things to consider
- IO loan repayments do not help pay off the principal and build equity. If property prices do not rise during the IO period of the loan, you will not have improved your financial situation. You may also be at financial risk if property prices should fall during the IO period.
- The loan reverts to P & I as soon as the IO period ends. If you take out an IO loan, you should plan for the end of your IO period. At that time, some lenders may allow you to renegotiate another IO term. Otherwise, you can plan for increased repayments, consider refinancing the loan, or selling the property.
- A loan with an IO period will cost more in interest over the life of the loan, than a loan that has P & I repayments from the outset. The cost differentials can be quite significant and should be clearly understood.
- You could miss the opportunity to pay down the principal while interest rates are low. Paying as much as you can off the principal while rates are low could mean that when interest rates rise, you will be paying those higher rates on a reduced loan balance. This could mean lower loan repayments and/or paying less interest in the long-term.
The team of FinKonsel mortgage brokers have all the tools required to identify the cost of IO loans. The law requires mortgage brokers like FinKonsel to find a panel lender that best matches your needs. If you have any questions about your interest rate or would like to discuss your home loan needs and discover the best solution to suit your needs, please contact the FinKonsel team.
Disclaimer:
The information provided in this fact sheet is not legal, taxation or financial planning advice. It has been prepared without considering your specific needs, objectives, and personal financial situation. Before acting on this information, we recommend that you consider carefully if it is appropriate for your needs, objectives, and personal financial situation. All loan products are subject to lender criteria and approval. Lender fees, terms and conditions apply.
FinKonsel Mortgage Broking Team – finkonsel.com.au
FinKonsel is a CPA and IPA Public practise. Vivek Perti is Credit Rep # 473246 authorised under Australian Credit License 389328. His number is 0434 810 388 and email is vivek@finkonsel.com.au