Thanks for the question Rachel.

There are some advantages of using an interest only loan for investment purposes, but they do come with a few caveats. Before you apply for an interest only loan it’s important you have a good understanding of what they are and how they work. 

An interest-only loan is a loan where you are only required to pay the interest for a set period of time. The maximum time is usually 5 years with the exception of some investment properties where a lender will extend to 10 years interest only. This means if your only paying interest, at the end of the interest-only period the principal balance remains unchanged, in other words the amount you originally borrowed will not have decreased.

The primary reason why investors may use this method to buy an investment property is that it maximises the interest deductions that you can claim when you submit your tax returns. It also reduces monthly repayments which may ease up your cash flow.

Some investors may opt for interest-only and any extra payments that are made would be paid into their owner-occupied home loan which is not tax deductible. This would reduce the owner-occupied loan quicker as they are not getting any tax benefits from that. When choosing an interest-only loan there is an expectation for some capital growth. Since you are not paying down the debt an increase in property value would be considered as negative gearing. This is where your expenses are more than your rental income and the investor would typically rely on an increase in property value to boot up equity.

What are the negatives of an interest only loan?

The negative to interest-only loans is that rates are now higher than the principal and interest rates, typically up to about half a per cent higher, 0.50%. As of March 2017, the regulator, APRA, imposed a cap on lenders, restricting them from financing no more than 30% of new residential loans with interest-only repayments. Previously, there were some lenders financing more than 50% of new mortgages with interest-only repayments. This concerned the regulatory board (APRA) that mortgages were not being paid. To discourage interest-only loans, banks increased interest rates and the lending of interest only repayments decreased.

Apart from higher interest rates, the principal balance remains the same and once the interest-only period term has ended it is the banks’ expectation that the loan principal and interest is paid over the remaining period. For example, you have a 30-year loan term with a five-year interest-only period, after the five-year interest only period is finished, you will need to repay the loan with principal and interest repayments over the remaining 25 years.

This really means a significant change in financial commitments. After the initial interest only 5 years, repayments increase to include interest and principal debt and the loan term in which to settle the remaining amount is now shorter.

“Mortgage prisoners” is a phrase conceived by the media that describes those who took out interest-only loans 4-5 years ago when eligibility criteria was not as stringent. After the interest-only period of 5 years, these people found themselves not able to qualify for loans they had and were unable to refinance or extend their interest-only periods.

Historically you would just extend the interest-only period or refinance it through another lender and secure a new interest-only period, however these “mortgage prisoners” no longer qualified, so they either rolled over the principal and interest if they could afford to make those higher repayment amounts or they were forced to sell their property.

In the past the majority of people would opt for an interest-only repayment for investment loan purposes. Today we are seeing a decline and clients opting for the principal and interest or at least part-principal and interest.

Considerations before taking an interest-only loan?

With any loan, it is wise to seek the advice of an industry professional, financial advisor or an accountant before deciding on a loan type. Investment property, interest only options do have tax-deductible facets and you want to be sure you are receiving the best product to suit your financial situation. What many people do is accept an interest only loan with 100% offset account which is an indirect form of credit, but at a cheaper interest rate.

Historically if someone was buying an investment property and borrowing money against their existing property to fund the the deposit, many people would take that money against their existing property as a line of credit. So, they’ll only draw down on that money when they need to and only pay interest on that money when accessed.

The trend today is to secure an interest-only home loan with an offset account and transfer the money borrowed from the home loan into the offset account. For example, you’ve borrowed $200,000 in a normal standard variable home loan against your owner-occupied or against your current property and you transfer that $200,000 into the offset account. You will make no repayments because you’re fully offset, and you’ll only start making repayments once you start using that money to buy the investment property.

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For more than 17 years Mortgage World Australia has helped hundreds of Australians realise their dream of owning their own home. Through our affiliation with the largest network of individual mortgage brokers in Australia we can help you find the right loan to suit your needs. Whether you are a first home buyer just starting out on your real estate journey, an experienced investor or you are just looking to get a better deal on your current home loan then give us a call.