Investment Property Financing: Interest-Only vs Principal and Interest Loans
Understanding investment property loans
It’s difficult to choose between an interest-only investment loan and a principal and interest one, with each option offering benefits and risks.
But this decision doesn’t have to be difficult if you have the correct information and great mortgage broker beside you.
- What is an interest-only investment loan?
As the name suggests, interest-only investment loans mean you only pay the interest on your home loan’s principal. As with principal and interest investment loans, interest rates on interest-only loans can also be fixed or variable.
- What is a principal and interest investment loan?
This property loan option is the most common one across the lender landscape and requires investors to repay their loan’s principal as well as its variable or fixed interest rate.
Key differences between interest-only and principal and interest loans
Now we come to the fine print of these two investment loan options.
For new property investors, in particular, these differences should be carefully considered before signing a loan contract as your decision will seriously impact your short and long-term finances.
- Repayment structure
Interest-only loan options can be enticing, as your mortgage repayments will be low compared to the hefty price tag of a principal and interest investment loan – initially, at least. These lower repayments at the start of a home loan period are particularly appealing as this can be a time when unexpected maintenance costs or tenancy issues can rear their unwanted heads.
In comparison, investors holding a principal and interest loans will have larger repayments throughout the life of their loan. Why? A principal and interest loan includes an interest rate portion and a principal balance portion, with the latter share gradually reducing the principal over time.
- Loan term and flexibility
The more common principal and interest loan has an average 30-year lifespan. But only some lenders offer interest-only loans and these loans only have five or 10-year terms, at best. Why? Interest-only loans equal a longer loan – and therefore, increases the chance of a mortgage default.
In another option for both types of loan holder, property investors can switch to a principal and interest loan or vice versa during the life of their current loan.
- Impact on cash flow
The main appeal of interest-only loans is the high, if short-term, cash flow they offer. This cash can pay for another investment, thereby diversifying your portfolio, or unexpected emergencies.
In comparison, principal and interest loan holders will need to brace themselves for larger repayments from day one of their mortgage.
- Tax implications
Interest payments on any loan are tax deductible for investors; therefore, an interest-only loan equals a handy tax break for you plus a reduction in your tax liability. This is especially useful for property investors aiming to negatively gear their home.
But there is still some good news for principal and interest loan investors: they can claim the interest rate portion of their loan as a tax benefit.
- Long-term costs
Unlike interest-only loan holders, principal and interest people won’t experience the financial shock of shelling out a much larger repayment, after a few years of much cheaper living.
They also won’t experience a doubly rude financial awakening: a larger principal due to increased interest rate during their interest-only period. At best, your principal won’t have reduced during this period.
But interest-only property owners switching to a new loan life can likely enjoy lower interest rates and more flexible terms.
Pros and cons of each loan type
Interest-only loans – pros:
- Initially strong cash flow with lower repayments
- Greater tax benefits
Interest-only loans – cons:
- Extends life of loan
- Higher interest rates
- Larger long-term repayments
- Limited loan terms from limited lenders
- Refinancing challenges
Equity may not increase if property value declines - Unreduced, or possibly larger, principal after loan expires
Principal and interest loans – pros:
- Faster total loan repayment
- Reduced principal and interest over time
- Lower interest rates
- Longer, more flexible terms
Principal and interest loans – cons:
- Higher repayments
- Lower tax benefits
Which loan is right for your investment strategy?
- Short-term vs long-term goals
Short-term, interest-only loans suit short-term property investors best.
These loans will also suit investors with an excellent handle on property market conditions or those who prefer high, short-term gains. In short, interest-only loans aren’t for the faint-hearted but rather, for those who know the risks and benefits of these loans, and market conditions, front to back and inside out.
In comparison, principal and interest loans are best suited to long-term investors who prefer steady, ongoing benefits. These loans are a great option for nervous new investors too.
- Risk tolerance and financial stability
Again, principal and interest loans offer the best financial stability for risk-intolerant property buyers such as new ones. Or, as I said earlier, only investors who have short-term plans for their property.
The opposite is true for interest-only loans.
Tips for choosing the right loan structure
- Always talk to your accountant before agreeing on which loan is best for you. Also ask yourself the following questions:
- Are you a long-term or short-term property investor?
- Do you want strong but temporary gains or long-term, higher benefits?
- Are you comfortable dealing with potentially high risks or not?
- How well do you know the overall property market including conditions and trends?
Speak to a mortgage broker or financial advisor
As well as talking to your accountant, talk to a savvy mortgage broker or financial advisor. Mortgage brokers can give you excellent advice on the best loan for you and your situation. They can approach lenders for you to find out the most favourable interest rates, fees and other costs and conditions for every loan option.
Final thoughts
Whether you choose an interest-only loan or a principal and interest option, make sure you have a solid financial strategy – both long and short-term – beforehand.
There are definitely excellent benefits to be had from both loans but it literally pays to carefully consider their ups and downs.
Ready to finance your next investment property? Speak to our expert mortgage brokers today for tailored advice.
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