Finance advice
David Johnston

Should you always have interest-only loans?

By David Johnston

Should I pay interest-only or principal and interest on my loan? This is an age old question that seems to be asked by every second person I speak to about their finances. Like with most things in life there are multiple factors to consider when working out what best is for you. 

Blogger: David Johnston, founding director, Property Planning Australia

Let me begin by saying that as a general rule reducing the interest payable on your debt is almost always a good idea. Just like saving money is basically always a good idea.

Where the answer to the repayment approach question gets confusing is when you start to actually develop a property plan for your future changes in circumstances. This planning will impact the way you structure your home loans.

Let’s break down some of the key factors that it’s important to understand –

1.    Debt/interest reduction - We always want to reduce the interest payable on our debt (note, that I don’t suggest reducing the loan balance or debt itself. This is a key distinction)
2.    Prioritise reducing non-deductible debt - Deductible debt is when you have borrowed for investment or business purposes and therefore can claim the interest as a tax deduction. If we have deductible and non-deductible debt we want to put all spare cash flow towards reducing the interest payable on the non-deductible debt. This is because the non-deductible debt is effectively more expensive as we cannot claim any of the interest as a tax deduction.
3.    Separate deductible and non-deductible debt - We want to keep non-deductible and deductible debt separate so we can focus on reducing the non-deductible debt. If the debt is combined into one loan account than any reduction is equally apportioned from an accounting perspective. This means you are unlikely to be maximising your tax deductions and reducing your non-deductible debt as rapidly as possible.
4.    Purpose Test - We only have one opportunity to borrow to purchase an asset. That is when we first purchase the asset. That means we cannot redraw on a loan that we have paid down and expect to claim the interest on the redrawn money in relation to the purchase of the original asset. This is because the redrawn funds will go towards a different expense to the original asset. In short, the ‘purpose’ that you spent any borrowed or redrawn money on determines whether the interest is deductible. (people often get confused by this point so I may expand on this in a future blog)
5.    Offset Accounts - The functionality of offset accounts can provide you with the maximum flexibility and the best of both worlds. This can allow you to pay interest only on a loan and still make effectively additional repayments (that otherwise would have gone directly into the loan account) into the offset account. This achieves exactly the same result as paying down the loan in terms of reducing your monthly interest. The key distinction is that your loan debit balance is not reducing and your savings credit balance is increasing.   
6.    Home becoming an investment - Is there is any chance the home you own currently will ever be an investment property in the future and you will purchase a new home? By paying interest only on the loan and placing all the additional repayments into an offset account you are building cash that could be used towards a future home purchase. You also will not have paid down your existing home loan which could provide you with the maximum tax deductions on that debt when it becomes an investment. If you had paid this debt down you would only be able to claim the interest deductions on the reduced balance. (see point 4)
7.    Purchasing a home in the future - If all your debt is currently tax-deductible, is there any chance you may purchase a home in the future? If there is, once again you want to have as little interest payable on the future home as it will be non-deductible debt. Therefore you should build up your savings/additional repayments in an offset account to be used towards purchasing the future home. This will minimise your non-deductible debt at that point and ensure that you have maintained the same level of tax-deductible debt.
8.    Flexibility/buffer – It’s always worthwhile planning for some flexibility into your finance strategy if possible. One way of doing this is by choosing to pay interest only on a loan and placing your additional repayments into an offset account. You are then provided with flexibility should your circumstances change as per point 6 & 7. You are also building up a buffer of savings which can provide you with a safety net should you have some unexpected bills or expenses.   

For many people, it is necessary to have ‘forced’ repayments. Otherwise they will spend the extra money. For those people it is a good idea to set up a separate savings account for their day to day banking. This maintains a barrier to ensure better money management. The offset account can work here too. However it should be treated as an off limits account, just the same as you would consider your redraw funds if the money was going directly into the loan.

The key point to understand is how powerful an offset account can be to your loan structure. The psychological adjustment and challenge for some people is to appreciate that making additional repayments into the offset can be viewed the same as paying those same dollars into the loan account itself.  

Having spoken to many hundreds of people about their lending, spending and banking habits I’m acutely aware of the complexities. Setting up the right loan structure is partly about gathering all the information, partly about properly understanding the information, and most importantly ensuring that you have a clear understanding of your future property plan and remembering that there is more to your loan structure than the interest rate!

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About the Blogger

David Johnston

David Johnston

David Johnston is the founding director of Property Planning Australia (PPA) and co-author of Property For Life - Using Property To Plan Your Financial Future. Property Planning Australia was established in 2004 and is a multi-award winning property, finance and financial planning consultancy that provides its clients with a holistic approach to financial and investment advice.

The PPA team specialise in developing holistic property strategies for first home buyers, investors, upgraders and those transitioning into retirement.

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Tune in to the latest episode of Property Showcase, the podcast with the inside track on the products and businesses that will help turbocharge your portfolio, maximise returns and make your overall investment experience seamless and stress-free!

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To hear more about these services, make sure to tune in to this episode of Property Showcase!

 Make sure you never miss an episode by subscribing to us now on iTunes!

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Son Pham is the accredited Head of Mortgages at Rethink Financing\/Rethink Investing. He has over 6 years\u2019 experience writing loans, over 12 years in the wealth management industry working for the likes of CBA, AMP and private practice and he is also a licenced financial planner (AFSL 326450). He has multiple investment properties that are cash flow positive which help pay his mortgage on his home and fund his lifestyle.<\/p>\r\n

Son is able to write all types of residential and commercial property loans.<\/p>\r\n

In this episode of Property Showcase, head of mortgages at Rethink investing Son Pham joins host Tim Neary to unpack how an investor should approach getting a mortgage in place with banks tightening down on serviceability.<\/p>\r\n

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    In this episode of Property Showcase, director of investment services for Open Corp Michael Beresford,\u00a0joins\u00a0editor of Real Estate, Tim Neary to share why he disagrees that the cooling market means that the best times are behind us.<\/p>\r\n

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Smart Property Investment" ["menu-meta_description"]=> string(91) "Financial tips for property investors, from mortgages to cash flow to saving for a deposit." 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Mortgages in a tighter lending economy and why Brisbane is a good option
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  string(82) "Stories of success: The migrants that became Australia’s renowned Property Twins"
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Sana and Mona Ali moved to Australia from Pakistan at the age of 15. Years later, the once-struggling migrants successfully turned their $40,000 savings into a $5 million-portfolio, earning the moniker “The Property Twins” — all before the age of 30. How did these millennials make their way to the top?

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The Ali sisters lived in low socioeconomic conditions for years since arriving in Australia in 2000, but instead of accepting their fate, they used their circumstance as motivation to work hard and achieve financial security.

According to Sana: “Moving countries was a huge personal challenge. We were living in a low socioeconomic area of Sydney and we just saw people around us living really good lives. It really pushed us and made us wonder, ‘What if we could buy more than one house?’”

They initially wanted just a strong financial foundation for themselves and their family and the sense of security brought about by owning a home. In less than a decade, they got all of it and more.

Aside from being able to build a 10-property portfolio, the Ali sisters were also successful in establishing a mortgage business that aims to help investors make the best decisions for their own wealth-creation journeys.

“We just want to feel that Australia is really home and to have our roots here,” Mona highlighted.

How it all started

What they lacked in funds, the Ali sisters made up for continuous education, training and mentorship.

In 2009, they have both spent years in the Information Technology and Project Management fields before progressing through finance roles. The high-net worth individuals that they constantly work made them realise that there’s more they can aspire for than corporate jobs.

They started doing research and eventually bought their first property in Parramatta through their combined savings of $40,000 and the aid of the First Home Owners Grant. Seven months later, they bought their second property in Blacktown.

Mona shared: “I personally wasn’t a good saver, because I loved shopping and shoes. Nothing wrong with that, but looking back, it's like a ‘need it versus want it’ question. Obviously, I did buy a lot of shoes but we didn’t go travelling and all of that. So, we did have some savings.”

The Ali sisters opted for cheap properties in the lower end of the market to jumpstart their investment journey for low-entry prices.

“The cash flow meant when we did rent the properties out, they could look after themselves,” Mona highlighted.

Sana and Mona advise investors to avoid being afraid of starting small. Being realistic instead of aiming for a dream home on their first shot at investing helped them enter the market sooner than later.

After all, property investment is a long-term commitment and, essentially, a kind of “delayed gratification”.

The twin’s property portfolio grew to consist of eight more properties spread across Western Sydney and Brisbane, including units, villas and townhouses.

Strategies

Not long after they started investing in properties, the Ali sisters sold their first two properties in Sydney to take advantage of the property boom that happened in the city. Prior to selling, they did cosmetic renovations on these properties to add value and eventually extracted equity from them.

The first property returned around $330,000 while the second property returned around $190,000.

Mona and Sana used the extracted equity to make their third and fourth property purchase, which are strata properties located in Blacktown. Less than 10 years later, the same properties have increased in value by 90 to 100 per cent.

As the market went more stagnant, Mona and Sana continued increasing their savings to improve the buffer for their portfolio. They saved 20 to 30 per cent of their salary, sacrificed travels, minimised eating out and drove a Kia Rio for years to save as much as they could.

For years, they carefully weighed their needs and wants to determine the things they could live without as they are building their portfolio.

Where to buy

The Ali sisters deliberately chose to buy most of their properties in the Western Sydney region, between Parramatta and Penrith.

According to them, having properties in such good locations, as in close to transport and other valuable infrastructure and establishments, helped them maintain good cash flow and minimise the impact of property investment on their finances and lifestyle.

While they have implemented different strategies throughout their investment journey, good location is one of their non-negotiables.

Sana explained: “We wanted to make sure the properties were well-located. That’s formed the foundation of our property strategy, where we make sure that properties are close to the train station, or a big shopping centre, because that’s what’s going to drive the demand down the track.”

Who to work with

Unlike many investors, the Ali sisters didn’t recognise the value added by property professionals to their portfolio in the beginning. In fact, it took them four purchases to seek the guidance of experts. Needless to say, it turned out to be among their more costly decisions.

According to Sana: “You don’t know what you don’t know, and we didn’t know any better. In hindsight, it would have been good to work with a broker for our initial couple of purchases.” 

Through online forums, they found out about the benefits of working with a mortgage broker and has since worked with a few throughout their investment journey. They taught them not only what they needed to know about mortgage broking, but also what they want to be done differently.

Eventually, Mona and Sana grew to love the “numbers side of property” and went on to establish their own mortgage business, The Property Twins. The business aims to empower investors by offering different services, including building portfolio roadmaps and finding better loans.

According to them, their personal experiences as investors consistently help them provide the best customer service and most effective advice even amidst changing broking spaces.

Mona said: “We really look at building road maps for our clients upfront. On paper, we really put the options down — lender A, B, C, D, in that order — so you continue maximising what's really possible for you."

“Whilst you have no control over the lending policies or where your interest rates go, if you’re making that strategic choice, you’re keeping a lot of doors open for later investment," she added.

Helping investors

As investors-turned-mortgage brokers, Mona and Sana seek to improve the knowledge of Australian investors and ultimately help them achieve their financial goals. Their experiences as investors who, quite literally, started from the bottom allow them to provide realistic and well-rounded advice to different types of investors.

Instead of acting as mere intermediaries who bring borrowers and lenders together, they take on a holistic approach and help budding investors establish a good foundation for their investment journey.

The most important advice they give to their clients is to always implement long-term strategies, but also be flexible enough to alter plans accordingly along the way.

Sana explained: “You need to look at the big picture rather than just one product or one rate focus, because it's a long-term strategy for you.” 

“We are taking our clients on a journey. It’s not about one transaction at a time, it’s about the big picture and really educating them through the process, through the decisions that they are going to be making — just talking through the pros and cons, the rates and how it's impacting them and what their plans are in the next six to 12 months," Mona highlighted.

Finding the right mentors is critical to success in property investment, according to them. Finding the ones who will be willing to understand your goals, capabilities and limitations as an investor and give you tailored advice will certainly help you fast track your wealth-creation journey.

In fact, Mona and Sana themselves have made it a point to stay in contact with their mentors even after they have successfully crossed the $5 million-line.

As mortgage brokers, the Ali sisters go above and beyond their responsibilities to serve as lessons and inspirations to budding investors.

Mona said: “It’s been really rewarding to see the changes that people have had or the smart decisions our clients have made over the last couple of months. Whilst we’re not property coaches or mentors, that naturally comes to us.

“We pretty much hold their hand and say, ‘Look, this is what we would buy, this is what would make a good property and this is what you should be looking for, and where you should be looking.’ When you’re working with someone who’s been there, where you want to go, you cut down 10 years’ worth of effort,” she concluded.

 

The information has been sourced from propertytwins.com.au, realestate.com.au, Daily Mail and the Smart Property Investment website.

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Stories of success: The migrants that became Australia’s renowned Property Twins
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Will Magee has had ambitions to enter into the Australian property market for quite some time, but it has been more than just finances holding him back.  Having been granted permanent residency just two weeks ago, Will is wasting no time and is now in the process of signing papers and finding his first investment property.

" ["fulltext"]=> string(2483) "

In this episode of the Smart Property Investment Show, Will joins host Phil Tarrant to share why he is purchasing his first property in partnership with his brother, discuss the complications that can arise from such a strategy, and unpack the ongoing plan for building a joint property portfolio with his brother.

Will will also share how they approached saving for their first property, why he is taking out the mortgage in his name exclusively, and share their savings plan for the year ahead.

If you like this episode, show your support by rating us or leaving a review on iTunes (The Smart Property Investment Show) and by following Smart Property Investment on social media: FacebookTwitter and LinkedIn.

If you have any questions about what you heard today, any topics of interest you have in mind, or if you’d like to lend your voice to the show, email [email protected] for more insights!

RELATED AREAS OF INTEREST:

From property in Australia to a ski lodge in Japan
Mortgage Trusts, an alternative first step for property investors
Should a real estate title be in one person’s name only?

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A property investment plan years in the making

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