5 Important things about Interest-only loans

An interest-only loan can be a great option when buying your first or an additional investment property. While it will largely depend on your investment portfolio plan and the timeframes you’ve set for growing your assets, interest-only mortgages have a range of risks and benefits. But first…

What is an interest-only home loan?

When selecting an interest-only mortgage, you will only repay the interest that accrues on the amount initially borrowed (i.e. the principal). An interest-only loan will usually be available for a set period, and once this period has ended, the loan will change to ‘principal and interest.’ This means paying back the amount initially borrowed, which increases repayments. 

While it does mean you are not decreasing the debt owed to the lender during this period, an interest-only loan is still a great option in the ‘acquisition phase’ of your investment strategy. However, when tossing up the interest-only loans pros and cons, it is critical that you decide with your personalised strategy in mind, recognising your investment property ambitions and limitations. 

With this in mind, here are 5 essential points to remember regarding interest-only loans…

#1 Interest-only loans preserve cash.

A big plus for interest-only loans is that they free up your money as repayments remain low. During the interest-only period, you won’t have to make repayments on the principal of your investment. The cash saved on not paying back repayments on the principal can be directed to your next investment. 

Preserving money for further investments is the perfect option for those looking to build their portfolio as quickly and efficiently as possible. 

#2 Interest-only loans interest rates can be higher.

But for those asking, ‘what are the risks of an interest-only mortgage?’, interest rates are probably the first concern that comes to mind. Around two years ago, an interest-only loan interest rate was around 0.25 per cent higher than a principal and interest loan. These days, the difference sits at approximately 0.5 per cent and sometimes even higher. However, this will always depend on the individual bank.

Higher interest rates will be a factor in the decision to go with an interest-only loan. Once again, this will depend on your strategy. If your focus is on building your portfolio as quickly as possible, and interest rates are a secondary concern, then an interest-only loan is probably the way to go.

But if you’re in less of a rush, then the higher interest rate may not be worth it, and the principal and interest loan could be the best option. 

#3 Interest-only loans help generate passive income.

The money saved from not paying off the principal during the interest-only period contributes to the passive income generated by that investment property. Selecting an interest-only loan when buying a $300,000, $400,000 or $500,000 property means that there is the potential to generate between $2,000 to $10,000 positive cash flow that’s clear of all costs every year.

While this can be put towards the next investment property, this money is passive income and can be used for other means. Perhaps a holiday is in order, or maybe some other personal purchase. The critical thing to remember is that selecting an interest-only loan generates passive income. 

#4 Interest-only loan periods can be extended.

When asking ‘how do interest-only home loans work?’ we mentioned that interest-only loan repayments can only be made for a certain period before having to switch to a principal and interest loan. This period is usually up to five years. However, this shouldn’t necessarily be seen as a limitation when considering an interest-only loan. There are easy ways to extend that time frame.

You can always approach your current lender to refinance with another interest-only period. It is unlikely they would object to the refinance, so long as your borrowing capacity is the same as what it was at the end of your interest-only period. 

If they don’t go ahead with the refinance, there is always the option to go with another lender. There will always be a bank that can give you another interest-only period. If you want to build your portfolio while preserving your capital, extending this interest-only period is a great strategy. 

#5 Interest-only loans can affect your borrowing capacity.

While these interest-only loan periods can be extended or rolled over, keep in mind that banks may penalise you if you’re holding a collection of interest-only loans. In this instance, it is worth considering where you are in your investment journey and whether another interest-only loan is worth it.

Say you’re seeking an additional $400,000 in lending to acquire your final property. Selecting another interest-only loan may limit the amount lent to you by the banks. Going with a principal and interest loan may be the better option, as you may be able to borrow more than if you went with an additional interest-only loan. 

The decision to select an interest-only loan will largely depend on your investment strategy. Do you need to build a portfolio as quickly as possible? Do you need to preserve cash for another deposit?

Or do higher rates and the impact it might have on your borrowing capacity mean that an interest-only loan isn’t for you? You may not have all the answers just yet, but Consulting by PK is here to help walk you through this process. Get in touch today!