What are interest-only property loans and how do they work?

By Vivienne Kelly
Interest-only loans

Interest-only 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 — but they’re certainly not for everyone.

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? 

These choices don’t come up just once. A property investor may decide to target an existing cash flow positive regional house with renovation and value-add potential for one purchase and finance the mortgage with one of the four major banks.

Their next purchase could be a brand-new inner-city unit that is slightly negatively geared but which offers massive capital growth potential. The loan could be from a completely different lender. 

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 and how well you handle your finances.

What is an interest-only home loan?
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. In other words, you’re not paying off the ‘principal’ part of the loan. The portion of your investment property that the bank ‘owns’ thus doesn’t reduce. You aren’t increasing your ownership of the property (your ‘equity’) as you would with a principal and interest loan.

Research firm CANSTAR has noted that interest-only loans are common within fixed-rate facilities. This structure enables borrowers to calculate future interest repayments and stay on top of their finances. In addition, some investors split their loans and have an interest-only portion to trim down their repayments.

Why do investors choose interest-only loans?
Interest-only loans tend to have a more flexible repayment schedule. In addition, because you’re only paying the interest part of the loan, the monthly repayments are lower than they would be on a principal and interest loan, which frees up additional cash flow.

Interest-only loans can appeal to property investors because they enable you to manage and minimise your mortgage repayments, the idea being that your asset will grow in value over the life of the loan.

Interest-only loans are also used by investors looking to ‘flip’ properties. These investors purchase properties which are expected to climb significantly in value and only hold onto them for a few years. Given that they’re looking to capitalise on the property’s surge in value — perhaps further assisted by a renovation — and to on-sell it within a few years, these investors don’t need to pay down the principal part of the loan.

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 are often said to suit disciplined and cash-conscious property investors. These investors are best placed to take advantage of the opportunities that interest-only loans offer without overextending themselves or being frivolous with their additional funds.

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.

Things you need to know before taking out an interest-only loan
These loans are not for everyone. Throughout the life of your interest-only loan, it’s important to remember that the principal on the property is not reduced. Therefore, you aren’t creating any equity by taking more ownership of your home. 

When the interest-only loan period is up, you still have to pay off the asset, and you’ll need to make sure you’re in a strong enough financial position to meet these obligations once the need arises.

By taking out a five-year interest-only loan, property investors are banking on the capital value of their asset increasing — so they will ‘create’ equity without having to part with the additional cash.

No investment is risk-free though, and if you’re financing your investments this way, it’s important to remember that there is the chance that your property won’t increase in value.

Interest-only loans are also generally considered a short-term solution or financial strategy. Investors don’t take out 30-year interest-only loans, with five years usually the maximum time period for these loan facilities.

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 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 for when the interest-only period ended to ensure they can afford the new repayment regime — which may increase significantly.

ASIC also warned that due to the seemingly lower repayments at the beginning of the life of the loan, borrowers can easily be tempted to borrow more when taking out an interest-only loan, which may not be in their best interest.

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.

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

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