Interest-only (IO) Loans

Loans

Traditional home loans consist of two parts, the amount you borrow (the principal) and the interest charged by a lender. The interest rate will differ between lenders, and depend on how much you borrow. 

These loans are referred to as principal and interest loans (P&I). However for property investors, you may be considering an interest-only loan. 

Interest only (IO) loans allow you to only pay the interest portion of the loan for a set period of time (usually up to 5 years). After this period, your loan will revert to a principal and interest loan.

Pros

• The main goal of any investment is to purchase an asset (in this case a property) that increases in value over time. 
• For property investors, interest-only loans potentially allow you to buy a property, reduce your loan repayments for the first 5 years, and then sell the property for more than you bought it for. You can then use the money to pay off the principal while still making a profit.
• Reducing your repayments also means increasing your profit margins when you secure tenants to rent out the property. 
• Additionally, during the interest only period, the interest payments can be claimed as a deduction against your income at tax time. 
• Some lenders may allow you to pay the interest only portion annually, which can reduce your taxable income.

Cons

• While tax deductions, and reduced repayments are a big plus, it’s important to note that interest-only loans mean the principal (the amount you borrow) will not reduce for the entire interest-only period. 
• At the end of an interest only period, the remaining balance of the loan must be paid to your lender within the loan period. 
• Ultimately this means it’s likely your repayments will be higher than before the interest only period. 
• You will also pay more interest over the life of the loan as you’re not chipping away at the principal during the interest only period. 
• There is also the risk that the property’s value doesn’t increase enough to pay off the principal amount you borrowed, and make a profit. 
• It’s important to understand the costs of owning an investment property, and to talk with your Buyers Agent about your goals and expectations for your investment property. 
• Your strategy will impact whether an IO or a traditional P&O loan is better suited for you. 
• It’s also important to note interest-only loans usually have higher interest rates than principal and interest loans and lenders may have stricter lending criteria when assessing eligibility.

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The Verdict

Understanding how to value a property is essential in becoming a seasoned property investor. It will also play a critical role in risk mitigation by preventing investors from over-capitalising their purchases. Property investing is a numbers game and being able to purchase quality properties at the right price will build the foundation for long-term success.