The pros and cons of interest-only property loans

The pros and cons of interest-only property loans

Interest-only property loans can enable property investors to minimise their mortgage repayments, redirect their cash to high-returning investments and take advantage of a booming property market.

Investors have a lot of choices to make when they’re building their property portfolios — where will they buy? Will they look in capital cities or regional areas? Will they purchase a house or a unit? Does the property need a renovation? Will the renovation need to be cosmetic or structural? Which is more important: cash flow or capital growth?

One of the choices investors will have to make with each new purchase relates to the structure and type of loan they will take out. Should you get an interest-only home loan for your property investment purchase or should you take the principal and interest option? The answer will depend on;

  • Your property investment strategy
  • How highly leveraged your portfolio is
  • How quickly you are purchasing assets
  • How well you handle your finances.

 

Interest-only loans are often touted as an effective finance mechanism for property investors. 

The loan is much like other types of mortgages — it is a debt instrument which is secured by your property — but the monthly repayments simply cover the interest part of the loan. You’re not paying off the ‘principal’ part of the loan. The only way you increase your equity is through capital appreciation.

Interest-only loans tend to have a more flexible repayment schedule. The monthly repayments are lower than they would be on a principal and interest loan, which frees up additional cash flow.

With the smaller loan repayments, investors using interest-only loans can redirect their funds to something with a high return or use the additional cash to invest at an accelerated rate.

Interest-only loans can also suit someone who is building or renovating their own home because the loan will give them access to more cash for their project and reduce their financial burdens.

Throughout the life of your interest-only loan, it’s important to remember that the principal on the property is not reduced. When the interest-only loan period is up, you still have to pay off the asset, or refinance. You need to make sure you’re in a strong enough financial position to meet these obligations once the need arises.

Interest-only loans are generally considered a short-term solution or financial strategy.

Interest-only loans have also been the subject of increasing speculation and scrutiny by industry watchdogs and regulators recently. In 2015, the Australian Securities and Investments Commission (ASIC) began reviewing lending practices and found that lenders who provided interest-only loans needed to lift their standards to meet consumer protection laws.

ASIC cautioned that in today’s low interest rate environment, borrowers needed to build in a buffer. The buffer is to their minimum repayments to account for any potential rate rises and increases in repayments. Particularly if they had taken out an interest-only mortgage. In addition, ASIC’s deputy chairman Peter Kell said anyone planning on taking out an interest-only loan needed to have a clear plan of action. Especially for when the interest-only period ends, to ensure they can afford the new repayment regime if required.

With so much to consider, it’s generally advised that property investors don’t simply take out interest-only loans because of affordability constraints. The risk with doing this is that once the loan reverts to a standard principal and interest loan, the investor may not be able to afford the increased repayments.

Interest-only loans are best used when they are accompanied by a sound property investment strategy and personalised tax and financial advice.

 

Image source: Money Magazine

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