How to use interest-only loans to your advantage

One of the first decisions you’ll have to make as an investor is whether to structure your loan as principal and interest or interest-only.

Various loan structures will suit one investment type or strategy over another, so it’s important to know exactly what you want to achieve from the property before you apply for the loan.

I’m going to delve deeper than the known pitfalls and benefits of interest-only loans, but before I do, these are the basics:

Pitfalls
• You won’t actually be building any equity through your repayments because you’re only paying interest, and not the balance on your loan. (Note: only a problem if you have purchased in a non-capital growth location and if you’re not servicing bad debt).
• A chain reaction follows on from the first pitfall and defeats the purpose of effective and successful investing: by not building equity you can’t leverage into another property.
• You may suffer financial hardship if you can’t manage the repayments after the interest-only period ends.

Benefits
• Allows first-home buyers to get into the property market sooner than they would be able to on a principal and interest loan.
• Enables investors to service a higher level of good debt due to them only being required to service the interest. If their serviceability allows, this will enable them to leverage into more investments.
• Smaller repayments in the short-term: this means freeing up cash to fast track the reduction of bad debt, and if you don’t have bad debt, this allows you to target the reduction of one of your investment loans, or enables you to leverage into more investment opportunities.
• Interest payments on investment properties are fully tax deductable, however any principal repayments are not.

The biggest pitfall of all
The biggest pitfall of interest-only loans doesn’t actually have anything to do with the loan itself – it’s you, the investor.

Taking out an interest-only loan and not using it to its full potential is one of the biggest mistakes you can make.

If you take out an interest-only loan but don’t have a good understanding of the full leverage capabilities, you might as well take out a principal and interest loan.

I’ll get to the strategy around interest-only loans in a minute, but first, there’s something you need to know.

What the banks aren’t telling you 
When a bank is looking at your serviceability for a loan, they factor in rate rises of one and a half to two per cent. So at the time of applying for your loan the interest rate may be two percent, but they will determine your serviceability at four per cent. 

This buffer allows for a huge amount of incremental rise before their lending reaches a dangerous debt service ratio – for them, of course. 

The RBA’s latest commentary on ‘households swimming in more debt than they can handle’ are, in my opinion, throwaway comments that do nothing more than scaremonger the average Joe who might have been considering investing until they read that. 

The thing is, bankers aren’t paid to educate investors and the marketplace. And there’s a good reason why. 

Could you imagine how many billions of dollars the banks would lose if their employees went around telling borrowers how they could use interest-only loans to their (the borrower’s) advantage? 

Re-education of the services and products provided by banks is needed, and it’s only people like us (independent buyer’s agents and exceptional mortgage brokers) who take the time to make sure you really understand this point. Yes, the banks might discuss it with you if you raise it with them, but the problem these days is that most advice is passive, i.e. ‘you ask me the question and I might give you the answer’. I prefer to share raw information with my clients so they are empowered to make informed decisions and to ensure they are always asking the right questions.

Using it to your advantage
Don’t just accept the banks’ business model for what it is. If you happily repay your mortgage at a rate they’ve dictated as ‘your serviceability’, you’re going to be disadvantaged from the get-go (which is exactly how they like it). 

Instead, abandon what the banks have drilled into you and consider this: obtain an interest-only loan and use it to your advantage. If an interest only loan is producing positive cash-flow, why not divert the excess funds off of your bad debt to eliminate the debts that have no financial efficiencies attached to them. 

Please make sure you speak to your accountant to ensure that this is in line with what will benefit you financially and also from a tax perspective.

I must note that this tactic will only work for investors who have strong financial discipline.

Those who currently have investment properties on interest-only loans are enjoying record-low interest rates, which means there’s definitely some left over cash. 

Obtaining the interest-only loan provides you with the flexibility to use your extra cash to pay down your remaining principle, fast track your debt reduction, and eventually leverage into higher value assets. 

Provided your investment property is located in an area with good prospects of capital growth, is currently being rented and you don’t have any major bad debt, you’re in a fantastic position to use the interest-only loan structure to your advantage.

The whole purpose of investing is to hold an asset for the least amount of expense in order to achieve the maximum amount of reward, and that’s exactly what interest-only loans (when used effectively) provide. 

Sidenote: borrowers who are not disciplined with spending and saving may find that an interest-only loan creates more problems than solutions, as it frees up extra cash, but also halts your mortgage principal at a standstill for several years.

This post originally appeared on www.wefindhouses.com.au