All Topics / Finance / What is the benefit of an interest only loan?

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  • Profile photo of andrea01andrea01
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    @andrea01
    Join Date: 2007
    Post Count: 16

    Hi Everyone,

    I would like to know if there is any benefit in purchasing a properyty with an interest only loan instead of  interest/principal.

    There doesn't seem to be a huge difference in the monthly repayment amount.

    Thanks

    Andrea

    Profile photo of Joseph12Joseph12
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    @joseph12
    Join Date: 2008
    Post Count: 57

    To free up cash flow as repayments are less and so to borrow more and buy more property, although the repayments at the start of the loan are mostly made up of interest and a minimal amount of principal. Over the long term as the balance reduces you will be paying less of the interest and more of the principal.

    However back in Feb 2005 your mortgage magazine edition under the heading 'Why property is a good investment' Steve Knight advised he pays principal and interest repayments.

    Probably due to increasing the equity in the property by having the principal reduced.

    If their is another reason or if i am incorrect please advise ?

    Profile photo of MortgagePlusMortgagePlus
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    @mortgageplus
    Join Date: 2008
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    The main benefit of an interest only loan is that it gives the borrower added flexibility. With a P&I loan, the lender expects a small amount of the principal to be paid off each f/n or month. Each time this occurs, the effective credit limit of the loan is also reduced. Also, your minimum monthly commitment is higher.
    An Interest only loan can easily be set up to have a repayment taken from your account that is greater than the interest due, and will also allow you to pay the principal down just the same as a P&I loan. The added flexibility is that the amount that has been paid off the principal can be accessed later (as available redraw), and if you anticipate your income might be tight for a given period, you can also keep your monthly commitment to a minimum by reducing your monthly repayment to only the accrued interest.

    P&I = 1 choice. A principal and Interest repayment and no further access to your funds.
    I/O = Several choices. Choose your monthly payment, Access you money in the future, Maintain an available credit limit.

    I hope that helps.

    Profile photo of carlincarlin
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    @carlin
    Join Date: 2005
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    Paying interest only means not just leaves more money to buy more IPs but also more money to pay down non-deductible debt on your PPOR. Can't see the benefit off paying down principal on an IP when you still have outstanding debt on your PPOR.

    Profile photo of Scott No MatesScott No Mates
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    @scott-no-mates
    Join Date: 2005
    Post Count: 3,856

    You should also keep in mind that an IO loan operates best in a rising market as your property value increases your loan remains static and your LVR decreases whereas in a falling market the risk is your loan may outstrip your capital (PI will at least contribute towards stabilising the LVR).

    Profile photo of god_of_moneygod_of_money
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    @god_of_money
    Join Date: 2008
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    Just beware of static or falling of property price in current investment climate.
    PI will maintain some LVR in falling maket.

    Profile photo of rukruk
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    @ruk
    Join Date: 2008
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    my reason for interest only loans.

    Borrow $400,000 in 2008.

    Pay it off in 2033, when $400,000 will be the cost of a small car.

    There are lots of other benefits too, as mentioned before, but I like this one the best.

    Profile photo of Richard TaylorRichard Taylor
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    @qlds007
    Join Date: 2003
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    What happens if 5 years down the track when you have paid off 100K of principal or so on your PPOR you decide to buy another PPOR and rent this one out.

    You need 100% + costs of the new purchase price but are shocked to realise that only the existing balance is deductible on your current home loan and that the new PPOR will have 106% borrowing of non deductible debt.

    Had you taken an interest only loan from the start (the interest savings is exactly the same) you could have switched the offset account to the new PPOR and now the full debt on the existing home would be deductible.

    Richard Taylor | Australia's leading private lender

    Profile photo of god_of_moneygod_of_money
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    @god_of_money
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    Yes ruk… but the total interest repayment over 25 years would be 1 million+
    You hope that your house will value at 1.4 million+  :)

    In today price, the cost of small car is less than A$20,000 and average sydney house price is A$550k
    If in 2003, the cost of small car is A$400,000 then the average of sydney price will be more than A$10 million

    Cheers

    Donald

    Profile photo of Event HorizonEvent Horizon
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    @event-horizon
    Join Date: 2008
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    I have another interest only question. I have an Interest only  loan on my PPOR with an offset account attached, AM i better of switching the loan to principal and interest and attached to the same offsett account. Is there actually any difference finanically. Advise appreciated..

    Profile photo of Richard TaylorRichard Taylor
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    @qlds007
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    Non at all keep it as interest only.

    Richard Taylor | Australia's leading private lender

    Profile photo of Shaun M SmithShaun M Smith
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    @shaun-m-smith
    Join Date: 2008
    Post Count: 18

    The good thing about interest only repayments is that your minimum monthly/fortnightly or weekly commitment is reduced freeing up cas flow. 

    If you have a variable rate facility you can generally make additional repayments at any time without penalty. If you have a fixed rate facility you can generally repay up to $10K per annum as a rule without penalty.

    Therefore when you have additional funds to pay down the loan you can, if you dont at the time you dont have to
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    Profile photo of kenzelkenzel
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    @kenzel
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    " What happens if 5 years down the track when you have paid off 100K of principal or so on your PPOR you decide to buy another PPOR and rent this one out.

    You need 100% + costs of the new purchase price but are shocked to realise that only the existing balance is deductible on your current home loan and that the new PPOR will have 106% borrowing of non deductible debt.

    Had you taken an interest only loan from the start (the interest savings is exactly the same) you could have switched the offset account to the new PPOR and now the full debt on the existing home would be deductible"

    To Richard – Please correct me if I'm wrong but I always thought that interest repayment paid on a non-income producing asset (i.e. PPOR) is not tax deductable regardless of whether it's an IP or IO loan.

    Profile photo of Richard TaylorRichard Taylor
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    @qlds007
    Join Date: 2003
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    Kenzel

    The interest on the balance as at the time you make the property a IP is deductible however you are unable to refinance and redraw the funds or take out any advance payments and still get the same deduction.

    The 100% offset account gives you the same benefit and the net savings is identical. Difference being when you move out and make the property an IP you can withdraw the cash funds in the offset A/c and the full interest on the loan balance becomes deductible. 

    Sorry if it sounds confusing it really isnt at heart.

    Richard Taylor | Australia's leading private lender

    Profile photo of kenzelkenzel
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    @kenzel
    Join Date: 2007
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    "however you are unable to refinance and redraw the funds or take out any advance payments and still get the same deduction."

    Richard – is this because the extra payments made were into a PPOR?

    What happens when the PPOR is turned into an IP with extra payments continuing and 6 months down the track you decide to refinance, is the extra payment you've made since the property has turned into an IP tax deductible?

    Profile photo of Richard TaylorRichard Taylor
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    @qlds007
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    Hi Kenzel

    The determining factor applied by the ATO to ascertain whether the interest is deductible relates soley to the  "Purpose of the Loan".

    By keeping the loan and the offset account separate their is no doubt and all you would do is link the offset account to the new PPOR when you rent out the existing property. 

    Richard Taylor | Australia's leading private lender

    Profile photo of JodieDJodieD
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    @jodied
    Join Date: 2008
    Post Count: 7

    Hi,
    Keen to understand this also, as we have been considering turning our PPOR into an IP.  We currently have our loan set up as an IO, with an offset.  However, about 12 months ago we refinanced and consolidated some other debts.  Does this have any impact on the potential deductibility of interest?
    Also, if we were to go ahead, and then in 6 mths time want to access some equity for personal use – using our (new) IP as security – does this have any negative effect on the overall loan?  Or, is it simply that this part of the loan is non-deductible?  If the latter, would we be advised to keep the equity loan separate / split from the current loan?
    Thanks, JD

    Profile photo of Richard TaylorRichard Taylor
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    @qlds007
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    Post Count: 12,024

    Jodie

    Mhhh sounds like a wee bit of a mess to me.

    I think you probably need a bit of overhaul there but certainly if you use the available equity in the house do set it up as a separate standalone account.

    Richard Taylor | Australia's leading private lender

    Profile photo of JodieDJodieD
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    @jodied
    Join Date: 2008
    Post Count: 7

    Hi Richard,
    Yes – it was a bit of a mess.  But, we thought we'd tidied everything up about 12 months ago.  By consolidating back then, have we created a problem for interest deductions?  What sort of overhaul would be required?
    The second question was more of a hypothetical – not planning to do this, but wanted to understand the implications if we did.
    Thanks for your response, JD

    Profile photo of Richard TaylorRichard Taylor
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    @qlds007
    Join Date: 2003
    Post Count: 12,024

    I would have tried to split the loan back to the original balance you used to purchase the new property and then a separate loan for the rest.

    If you had some equity in the original purchase price (and on the basis that the loan did not exceed the original purchase price) then you might get away with some consolidation however cleaner to start with a fresh lender rather than have loan statements that show a redraw or refinance in them. Make the original loan Interest only and the non deductible part P & I and link the 100% offset account to this loan.

    Drop me a line if you need any other clarification.

    Richard Taylor | Australia's leading private lender

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