An ‘interesting’ strategy: A warning for rate chasing investors, and renewing interest in interest only loans.
Welcome! if you’re an existing or potential property investor, are your investment property loans interest only? Why do I ask? Well, in recent times, I’ve been quite disappointed to hear that in our KnowHow Finance broking business, many investors have gone rate chasing to get the lowest rate on their investment property lines and have switched from interest-only to principal and interest without considering the much bigger consequences.
What do I mean by this? Well, in the run up to the Royal Commission on Banking a couple of years ago, interest-only loans copped a lot of bad press as an irresponsible option to meet borrowers needs. But like anything, interest only does have its place, and it creates some great benefits for investors. As a result, interest-only loans are now much harder to get and come at a higher rate premium than principal and interest loans. Interest-only investment loans are currently approximately 0.2% higher than principal interest investment bonds, especially with the big four banks. Then even bigger differential with some of the second tier lenders. But by switching to a lower principal and interest rate, your actual repayments go up.
To illustrate this, as a broad rule of thumb, converting your loans from interest only the principal and interest at the same rate increases your repayments by somewhere between 35% to 55%, depending on the loan size and the lender. So a $1000 a month repayments on an interest-only loan can increase to about $1500 a month on a principal and interest loan. Now, even if the principal interest rate is a quarter of a per cent cheaper than the interest only rate, the monthly payments are still increased. So why is this a problem for investors? Well, probably property investors who still have a home loan and have gone rate chasing to get the lowest rate on their investment loans by going principal interest are actually missing the point. They’re also missing the significant benefits they give up by chasing low rate instead of lowest cost.
In a nutshell, going principal and interest on your investment loans when you still have a home loan means that you reduce your cash flow affordability, you reduce the pay down of your home loan, and you reduce the tax deductibility of your investment property. By going principal interest on all of your loans, you end up paying a little bit off all of your properties, but take a lot longer, like years longer, to own any of your properties freehold. So, why am I suggesting you go interest only on your investment property loans with an offset account while remaining principal and interest on your home loan? Well, if you have a non tax deductible home loan, one of the little known benefits of investing is to use investment property to help pay off your non-deductible home loan years earlier, as well as save yourself tens of thousands of dollars or more in interest. By keeping your investment loans interest only instead of principal interest, the surplus moneys can be channelled into your home loan offset account to help you pay it off and get freehold ownership of your home a lot quicker.
In addition, by keeping your investment loans interest-only the reduced repayments improve the cashflow affordability of the property and the resulting cashflow surpluses can also boost your borrowing capacity as well as the savings for your next property. The other important consideration is that if you convert your investment loan to principal interest, then you’re effectively paying the loan down and in so doing, reduce the tax deductibility of the diminishing interest on the loan. Conversely, by keeping your investment loans interest only with an offset account, your investment loan remains fully drawn and you maintain maximum tax deductibility on the loan interest.
To see what loan structure is best for you and your specific situation when everything’s considered, reach out to a savvy mortgage broker and your account. The take home message. If you’re a property investor with the home loan, don’t just focus on low rate loan chasing, but consider your overall cost position. As an investor in the accumulation stage of your property, journey, interest-only is your only interest on your investment property loans. That’s more food for thought on Bushy Martin from KnowHow Property Finance and the host of the Get Invested podcast. Have a great week.
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