Why Interest Only Loans No Longer Make Sense
Poor financial decisions have been bleeding humans dry for centuries. One of them, which I see over and over again, is investors taking out interest only loans when they're far better off paying principal and interest.
Almonds. 10 years ago I let a financial adviser I barely knew convince me to invest in an almond farm I’d never seen to help offset tax. Over the next five years, I paid thousands of dollars in deductible management fees and interest, ultimately losing thousands on the whole scheme. It’s the single worst financial decision I’ve ever made.
Poor financial decisions have been bleeding humans dry for centuries. One of them, which I see over and over again, is investors taking out interest-only loans when they’re far better off paying principal and interest.
The truth is, interest-only loans used to make a lot of sense… 10 years ago! Advisers and brokers recommended going I/O for investor loans, as only the interest is tax deductible. It was a good idea to go down that path to free up cash flow and maximise the tax-deductible portion of outgoings (the interest part of your home loan repayment).
Today, the story is very different. Price pressures from industry regulators have increased the cost of interest-only loans so much that, for most property investors, choosing an interest-only loan could be costing them thousands.
With a traditional principal and interest loan, borrowers typically benefit from paying a lower interest rate than they would with an interest-only loan and – by making principal repayments – are able to reduce the overall amount they owe immediately. Because of this, principal and interest loans work out to be cheaper and investors who choose these loans over interest-only loans are usually better off from year one.
Let’s look at a practical example. Take, for instance, Davinia, who earns a salary of $118,000 a year. She wants a loan of $544,000 to buy an investment property worth $680,000, which she plans to rent out for $300 per week.
Davinia is weighing up the merits of choosing an interest-only loan, at a rate of 4.3 per cent, versus a principal-and-interest loan at 3.89 per cent.
If she opts for interest-only:
- Davinia would gain an additional $937 tax benefit by going interest-only
- She’d also enjoy a lower monthly mortgage repayment
- However, over the first year, she would pay an extra $2403 in interest.
If she opts for principal and interest:
- Davinia would slash $9764 from her investment property home loan balance in the first year alone.
- This means the net benefit of Davinia choosing a principal and interest loan over an interest-only loan is $3865… and that’s just in the first year
- Over five years, the benefit of Davinia choosing a principal and interest loan is $25,803
For Davinia, the choice between an interest-only loan and a principal and interest loan is an easy one. And this is the case for a growing number of investors.
As a general rule, unless you have major cash flow issues, you’re burning money. Stop doing that and start getting the advice and service you deserve as a property investor.
The information above is general in nature, and you should always seek professional advice when making financial decisions.