As an investor, keeping your expenses down is one of the fundamental rules of ensuring you gain a greater return on your investment. And arguably one of the most significant ongoing costs for a property is the mortgage repayments.
A common investment strategy taken up by Australian property investors to reduce their expenses is opting for interest only home loan repayments. And with the cash rate tipped to rise and property values are forecast to fall in the next few months or years, reducing your expenses as an investor may be more important than ever.
Let’s explore the key differences between the home loan repayment types and which one may be better for borrowers to consider in 2022.
Differences between principal and interest and interest only repayments
When you repay a home loan, there are two main ways of paying off the debt:
- Principal and interest repayments – in which both the loan amount (principal) and the interest charged is repaid through weekly, fortnightly or monthly repayments.
- Interest only repayments – in which only the interest charged on the principal is repaid for a fixed period of time (typically one to five years).
The standard investor home loan will generally be on principal and interest repayments, however many investors may opt for the interest only option instead. This is because repayments on an interest only home loan are significantly lower than repaying the principal as well.
For example, on a hypothetical 30-year $500,000 home loan at a rate of 2.39%, your monthly repayments would be $1,947. However, if you opted for interest only repayments for the first five years, your repayments would be $996 during this time. This is a saving of almost $1,000 for property investors.
Interest only repayments: $500,000 home loan
|Monthly repayments (5 years)
|Monthly repayments (25 years)
Principal and interest repayments: $500,000 home loan
To calculate your potential interest only repayments, please use Reduce Home Loan’s Repayment Calculator.
How do interest only repayments benefit investors?
As you can see, one of the main benefits of an interest only home loan repayment is that it significantly reduces the ongoing expenses of your investment property.
As the principal repayments made on your mortgage are a non-deductible cost, opting to only pay interest charges will boost your cash flow and annual return throughout the interest only period. In turn, this may allow you to re-invest that cash flow back into the asset through repairs or renovations to boost its market value.
And speaking of deductibles, interest repayments on an investment property are considered to be fully tax deductible for investors. Interest only home loan rates typically tend to be higher than that of principal and interest loan repayments as the actual loan amount is not being reduced, so there is greater risk to the lender. And investors are typically charged higher interest rates than those offered to owner-occupiers.The higher cost of an interest only loan is made more affordable if you are able to pay less tax on the property.
That being said, if the cost of owning your rental property outweighs the income it generates, such as through the cost of principal and interest repayments versus the rental income you receive, you may qualify for negative gearing. This means that there still may be tax benefits to your property investment even if you make principal and interest repayments.
Further, unless you continue to refinance to extend the interest only period, you will eventually need to repay the principal over a 25-30 year loan. But, if you are planning on selling a property quickly – also known as flipping – then making interest only repayments may boost your return on investment if you sell before the interest only period ends. By never repaying the loan principal until it’s time to sell, you’ve kept one of the biggest ongoing expenses down for the duration of your ownership of the asset.
What are the risks of interest only repayments for investors?
There are some disadvantages of interest only repayments that property investors may want to keep in mind.
If you plan on holding the asset for an extended period of time, you may find your interest only repayments have reverted to principal and interest. If, for example, you begin making principal and interest repayments on the aforementioned 30-year $500,000 home loan after five years, you’ll find that your new monthly repayments are $268 higher than if you just paid principal and interest from the start.
This is because over the interest only period you never reduced the principal owing. Essentially, your new home loan repayments are calculated as being spread out over 25 years instead of 30 years. And the shorter your loan term, the higher your ongoing repayments.
Further, property owners may grow equity in a few ways:
- Paying down the mortgage (which isn’t occurring on interest only repayments)
- Waiting for capital growth (which is never guaranteed)
- Renovating and modifying the home to add value
If your property does not increase in value during your interest only period, you risk not building up any equity. And if property prices fall, as they have been forecast to do following a cash rate hike in the future, your interest only repayments may put you at risk if you want to sell.
How to get an interest only home loan
Ultimately, it comes down to the property investor’s financial situation and goals as to whether an interest only home loan is a better fit than making principal and interest repayments.
Property investors that have carefully projected their rate of return on their investments, have spoken to their accountant about potential tax deductions, and have chosen to buy in areas with opportunity for growth, may be in a better position to consider interest only repayments.
If you’re considering holding on to your investment property for decades to come, it may be worth considering repaying the principal amount as soon as possible. Ideally, the rent you earn from your tenants should go towards the majority, if not all, if your investment property mortgage repayments. Once the mortgage has been paid in full, the passive income earned from your asset can go straight to you instead of the bank.
Further, it’s worth keeping in mind that regardless of if you are a long-term investor or a first home buyer, there are features that may help you to reduce the cost of your home loan, including utilising offset accounts, redraw facilities or making extra repayments.
If you’ve considering an interest only investment loan to help finance your first or next home purchase, it may be worth considering a low rate home loan option.
Reduce Home Loans offers some of the cheapest variable rate and fixed rate home loans in Australia, helping investors to keep expenses low – whether or not they pay interest only or principal and interest. Compare our investor home loans, including 2.39% interest-only repayments (2.48 comparison rate) with the Investor Rate Cutter Home Loan, today.
If you’re considering an interest only home loan, or if you want to speak to an expert for more specialised financial advice, please don’t hesitate to call us on 1300 733 823.
Any statement/s are general in nature and do not take into account your financial personal situation, objectives or needs. You should consider whether any statement/s is suitable for you and your personal circumstances. Before making any financial decision, consider your circumstances and the product disclosure statement.