Interest only lending – the good, the bad and the ugly (part one)
Interest-only lending in the headlines a lot lately, isn’t it?
As I’ve written and spoken about before that’s because of a clampdown on this type of lending by APRA.
This has meant that lenders are reducing their ratios of interest-only loans as well as increasing interest rates for new and existing interest-only borrowers. This is as a direct result of APRA’s directions to reduce all interest only lending to within 30% of all new loan applications received by lenders. As we’ve written previously, this had got to more than 40% of all new applications and the regulators have had their concerns by world standards.
But is interest-only lending really the bad guy?
Well, not if you ask me – as long as it’s used correctly.
But let’s take a look at the good, bad and the ugly to see for ourselves, shall we?
In this first part of my special three-part series, let’s consider how interest-only lending can be a good idea.
Interest-only loans are not new.
In fact, they’ve been used by residential and commercial borrowers for decades.
The difference of late, however, is that some owner-occupier borrowers are paying interest-only because of affordability considerations.
But there are a number of valid reasons why you should consider an interest-only loan.
Before I start, I need to disclose that I believe that only investors should use interest-only loans unless there are mitigating circumstances i.e. you plan to keep the property as an investment when you move again in the future for example.
If you’re relying on interest-only to meet the mortgage repayments on your home loan, then you might need to talk to a professional about your financial circumstances.
Now that I’ve got that off my chest, here are some reasons why interest-only loans are good.
1. It balances and assists with your cash flow
Successful property investment is all about cash flow so with an interest-only loan, you can manage your cash flow better over the long-term.
To make the most of the power of compounding and leverage, you need to hold your investment properties for as long as possible – and the only way to do that is to have financial buffers or cash flow.
Interest-only repayments mean that you’re only paying the minimum required to service your loan, which leaves more in your back-pocket to pay for any additional expenses such as council rates or repairs.
2. It allows you to prioritise your debt allocation (non deductible vs. deductible)
Non deductible versus deductible debt is the difference between debt that makes us richer and debt that makes us poorer.
Interest-only repayments mean you’re servicing your loan while your property grows in value over the years, plus those interest-only repayments are deductible from your income, which can reduce your tax.
Meanwhile, you can pay more off non deductible debt such as credit cards, which is bad debt unless you pay off the balance in entirety every month as well as concentrating your efforts on your principal home loan. Paying this off should be everyone’s priority.
3. You can buy and hold more property
Based on your lower repayments it is easier to build your portfolio.
When you add in your additional rents plus that the interest is tax deductible and the lenders use this in their calculations, it should assist you.
4. Offset accounts reduce repayments even further
Offset accounts are a great invention if you ask me. They work by allowing you to transfer any additional savings into an account that is linked to your mortgage.This money is then used to offset your mortgage, which then reduces your interest repayment amount.
Say you have a $500,000 investment loan that has a 4.5 per cent interest rate. Your average monthly interest-only repayment would be about $1,875. But if you have, say, $40,000 in savings in an offset account, then your repayments are calculated on $500,000 – $40,000 = $460,000.What that means is that your average monthly interest-only repayment is reduced from $1,875 to $1,725 – or a reduction of $150 a month!
What that means is that your average monthly interest-only repayment is reduced from $1,875 to $1,725 – or a reduction of $150 a month!
Who doesn’t want to pay less interest than they have to?
5. Tax effectiveness
Last but certainly not least is the tax effectiveness of interest-only loans.
In Australia, it is permissible for investors in all types of businesses to claim any costs associated with owning that asset and that includes interest on loans.
For property investors, the interest component of their property loans is added to the annual costs of owning a real estate investment.
Of course, that is offset by the income earned via rent.
For example, an investor may pay $21,000 interest in one year, but that property produced income of $24,000, which means a “profit” of $3,000 – before other expenses are added in.
By using interest-only loans for your investment properties it becomes simple to calculate what your annual repayments were.
Lenders also calculate this for you at the end of the financial year so it can be as easy as copying and pasting that figure into your profit/loss statements or spreadsheets for each property.
The lending landscape is more complex than ever at present.
There is a concentrated focus on interest-only loans, but that doesn’t mean they’re not still available or that they can’t be used effectively to grow your wealth.
The world of banking and finance can be a pretty daunting one for both novice and sophisticated investors and since our establishment in 2002 we’ve focused on providing outstanding service and business standards.
This approach was vindicated when we were named Victoria’s favourite mortgage broker at the Investors Choice Awards.
So, if want to learn how to make the most of interest-only loan products, why now contact Intuitive Finance today to ensure you have the right information and expert support on your side from the very beginning.
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