Interest Only vs P&I Loans for property Investors
Introduction
Property investment is a popular avenue for wealth creation in Australia, with a variety of financing options available to investors.
Among these options, two of the most common are interest-only (IO) loans and principal and interest (P&I) loans. Both have their advantages and disadvantages. The choice between them can significantly impact an investor’s financial strategy.
In this article, we will delve into the nuances Interest Only vs P&I Loans for property investors. We explore key differences, benefits, risks, and considerations associated with each.
Understanding Interest-Only Loans
With an interest only loan the borrower pays only the interest on the loan amount for a specified period, generally between one and five years. During this period, the principal amount borrowed remains unchanged.
After the interest-only period expires, the loan typically reverts to a principal and interest repayment structure. The borrower starts repaying both the principal and interest and the loan balance reduces.
More info can be found here: https://moneysmart.gov.au/home-loans/interest-only-home-loans
Benefits of Interest-Only Loans
- Lower Initial Repayments: The most significant advantage is that they offer lower initial monthly repayments. This can be appealing to property investors as it frees up cash flow. It also allows them to direct funds towards other investment opportunities or reduce their owner occupier home loan.
- Tax Deductibility: In Australia, interest payments on loans for investment properties are tax-deductible. Investors can claim interest payments as a tax deduction against their rental income, potentially reducing their taxable income.
- Potential for Capital Growth: By minimising initial repayments, property investors may be able to purchase additional properties, diversifying their portfolio and increasing their potential for capital growth over time.
- Flexibility: Interest-only loans provide flexibility to investors, allowing them to make additional repayments if they choose, without penalty. This helps when an unexpected financial windfalls occurs or the investor’s financial situation improves.
Risks and Considerations of Interest-Only Loans
- Higher Overall Interest Costs: While interest-only loans offer lower initial repayments, they can result in higher overall interest costs over the life of the loan. Lenders often charge higher interest rates too. This is compounded by the fact that the principal balance remains untouched during the interest-only period.
- Limited Principal Repayment: The delayed repayment of the principal means that investors will not build equity in their property during the interest-only phase. This could leave them exposed to market fluctuations.
- Refinance and Sale Risks: Investors who rely only on property price growth may face difficulties refinancing or selling, if the property price drops unexpectedly. The sale cost or property valuation may be lower than the loan amount. This is called ‘negative equity’ and is a difficult position for investors.
- Reduced borrowing power: Lenders will often reduce the amount of money you can borrow based on the fact that the loan term is extended by the interest only term.
Understanding Principal and Interest Loans
Principal and interest loans, often referred to as P&I loans, are a traditional mortgage product. The borrowers makes regular repayments that cover both the interest and a portion of the principal. Over time, the principal balance decreases, leading to increased equity in the property.
Benefits of Principal and Interest Loans
- Equity Building: With each monthly repayment, property investors using P&I loans build equity in their property, increasing their stake in the property over time. This equity can be used to provide a deposit on the next investment property. It could also help negotiate a lower interest rate with your lender.
- Lower Overall Interest Costs: P&I loans typically result in lower overall interest costs compared to interest-only loans because borrowers are steadily paying down the principal balance.
- Reduced Market Risk: Investors using P&I loans are less exposed to market fluctuations compared to those relying on property price appreciation to cover principal repayment. This can provide a more stable financial foundation.
Risks and Considerations – Interest Only vs P&I Loans
- Higher Initial Repayments: P&I loans have higher initial monthly repayments compared to interest-only loans. This can strain an investor’s cash flow, especially if they have multiple properties in their portfolio.
- Limited Cash Flow for Other Investments: Higher monthly repayments can restrict an investor’s ability to leverage their capital for other investment opportunities or property-related expenses.
- Reduced Tax Benefits: While interest payments are tax-deductible for investment properties, the portion of the repayment that goes towards the principal is not. Therefore, P&I loans may result in a lower tax deduction compared to interest-only loans.
Choosing the Right Loan Structure
The choice between Interest Only vs P&I Loans depends on several factors, including an investor’s financial goals, risk tolerance, and current financial situation.
Here are some key considerations for property investors with Interest Only vs P&I Loans
- Investment Strategy: Investors with a short-term strategy, such as “flipping” properties for quick profits, may prefer interest-only loans to maximise cash flow. Long-term investors looking to build a substantial property portfolio may favor P&I loans to steadily accumulate equity.
- Risk Tolerance: Investors should assess their risk tolerance carefully. Interest-only loans may be riskier in a declining property market, while P&I loans offer more stability.
- Financial Situation: Evaluate your current financial situation, including income, expenses, and existing debt. Ensure that you can comfortably meet the higher initial repayments of a P&I loan without compromising your financial security.
- Market Conditions: Consider the state of the property market. In a booming market with strong capital growth, interest-only loans may be attractive. In a stagnant or declining market, P&I loans could provide more security.
- Exit Strategy: Determine your exit strategy. How do you plan to realise profits from your investments? P&I loans can help build equity over time, while interest-only loans may require capital growth to be profitable.
Conclusion
Interest Only vs P&I Loans
Interest-only and principal and interest loans each have their own set of advantages and drawbacks for property investors in Australia.
The choice between them depends on your financial goals, risk tolerance, and market conditions. It’s essential to thoroughly evaluate your options, seek professional advice. Your QPIA (Qualified Property Investment Advisor) will help formulate your lending strategy.
Ultimately, the right loan structure can significantly impact your success as a property investor.
