One decision you will make as an investor getting a loan is to opt for a principal interest or an interest only loan. Before we analyse these two options, what does principal and interest mean?
The ‘Principal’ is the quantity of money the individual borrows to buy an asset. Interest is the additional money the individual is charged by the lender, for borrowing the principal. Put two and two together, you have a principal interest loan.
Principal Interest (P&I) loans are when the borrower repays both the interest on that loan and the outstanding principal. This arrangement implies a borrower pays more per payment than an interest only loan. The intention is to pay down the whole and become debt free. This decision may be a smart if the borrower aims to live in the property.
By repaying the principal sum, the borrower increases their equity stake in the property whilst at the same time, reducing the amount of interest payable on the residual balance. This strategy will ultimately result in the individual owning the property outright.
These loans can however create a significant financial burden; often borrowers are contributing an additional 20% more of their disposable income towards the mortgage every month in comparison to an interest only loan. Also, these payments on the principal are not tax deductable for investment properties.
Interest Only loans are exactly what they sound like: a borrower pays only the interest on their loan. In Australia 2 out of 3 investor loans are interest only.1 These loans are particularly popular with investors as they allow investors to reduce their mortgage repayments as they only required to pay the interest component on the loan and not the principal.
This structure lets investors get their foot in the door allowing them to purchase a property whilst committing a substantially lesser amount of their disposable income. Additionally, these interest only payments are tax deductible.
Under this structure, the aim is to reduce your cash outlay in the short term, whilst the investment property appreciated in value over time; resulting in capital growth. It is common for investors to then access the equity realized from capital growth of the property to roll over into their next investment property.
To help make interest only loans worthwhile, it’s common to open an offset account linked with the loan. Offset accounts help reduce the amount of interest borrowers pay on their loan. Investors are charged the interest on the difference of the debt and the amount in the offset account.
On the other hand, as borrowers use this option they must not forget that they still have to pay back the loan eventually. Once the interest-only period ends (usually after 5 or 10 years), investors must be certain they can financially support the principal and interest loan.
Whether you decide to pay principal interest or interest only loans is up to an individual and their financial situation. The most important is thing to perform due diligence and understand all risks.