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Interest Only Loans – what are they all about?

Just this past week, I’ve had a couple of people ask me about Interest Only Loans and their questions got me thinking about whether this important financing option for investors is really properly understood. (Interest Only loans are where you only pay off the interest on the loan every month, never reducing the principal.)

You see, Interest Only Loans are something that I take for granted. I understand the importance of cash flow and the benefits you get from negative gearing, simply because I deal with this stuff every day. Finance is second nature to me because I have been involved in it for over 30 years. 

But after speaking with several new investors, who didn’t really understand the importance of such things, I thought it was time to share my views with you.

So, what is an Interest Only Loan and why is it such an important part of a property investor’s finance strategy? And, for that matter, why should owner occupiers consider it too?

Interest Only repayments can apply to either a Variable Rate Loan or a Fixed Rate Loan.

Paying the interest only is basically the minimum standard for any investment loan. Why is that so? Well, simply because paying off the interest only creates the lowest possible repayment option for that Loan and effectively improves the cash flow of the property. Let me expand on that a little bit. Typically, interest is accrued on a daily basis. By selecting an Interest Only option you could say that you are just buying time. It’s a bit like renting a car. You pay for the privilege of using it, then when the time is up, you return it. In our case, returning it means reverting to standard Principal & Interest repayments or, perhaps refinancing through another loan provider.

Repayments on Interest Only Loans are calculated daily on the amount outstanding and paid monthly. There is no requirement for any payment towards the outstanding Principal to be included in the repayment. Remember, it’s paying off the Principal that repays the loan; the Interest is the cost of having the money. So with no Principal component included in your repayments you are not reducing your debt but you do have the lowest repayment amount you can get.

Your contribution to the loan is the difference between the rent and the repayment. That means you put in the least amount of money to service the loan on the property.

Interest Only is not primarily about Negative gearing. Negative gearing can occur if you have Principal and Interest payments as well. An Interest Only Loan simply reduces your contribution to the minimum amount you are required to pay each month.

Obviously you will have more income available than the minimum required interest repayment or else you wouldn’t get the loan in the first place. Therefore, the strategy is to get your monthly payment to the minimum amount so you have the maximum surplus left from your income. For the average investor this surplus would go towards reducing the Home Loan balance.

It’s also important to remember that the loan balance will not reduce when paying interest only. For an investor this is not a problem as the long term hold of a property will usually be accompanied by growth as well as the normal increase in rent. Also, refinancing of an investment debt is a normal part of the cycle.

For those borrowers who want to pay off their debt there is still flexibility available. Extra repayments, or lump sum repayments, can be made at any time and you can also access these additional repayments through redraw, just like a normal loan.

This flexibility is also what makes an Interest Only Loan, something you could consider for your Home Loan as an Owner Occupier too.

The benefit of having an Interest Only loan means you can control how much Principal you pay off each month, as long as you have a variable loan of course. Rather than the Bank dictating what the repayment is going to be, you can decide the amount of Principal you will pay.

You can also access the extra funds through redraw if you need to. This is particularly useful to anyone whose income varies month to month, such as self-employed or commission based employees.

On the other hand, Principal & Interest repayments will always work towards reducing the outstanding debt, but you should bear in mind that under this arrangement you cannot get back the Principal portion without asking the Bank for it.  This will require a new application which means your financial situation will have to be assessed and this takes time. Clearly, not the most efficient way to get your money back, especially if the need is urgent.

Another point to consider is that Interest Only terms only comprise a part of the original loan term. If you have a 30 year loan it is normally made up of 5 years Interest Only repayments followed by 25 years of Principal & Interest repayments. Most Lenders will offer a maximum Interest Only term of 5 years, although some Lenders will go as high as 10 years. One trend that’s emerging with Banks lately is their reluctance to increase an Interest Only term. Once you complete the 5 year term they prefer you to revert to Principle & Interest so that the loan can be repaid under the terms of the loan offer.

However, I believe the end of an Interest Only term is a great time to look around to see what else is available. For an investor, Interest Only can be crucial to their cash flow and taxation position. If your Lender won’t give another Interest Only term then the only alternative is to refinance with someone who will.

Interest Only makes a lot of sense for investors and Owner Occupiers. Investors will use the interest only to minimise their contributions to a rental property while Owner Occupiers can make good use of the flexibility it provides.

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