Did you know that when you apply for a home loan you have the option of two repayment types? In this article, we’ll explain interest only loans and provide a real life example of how they can benefit those with an owner occupied and investment property.
A mortgage is typically made up of two parts:
- The principal - the amount you borrow
- The interest - the amount the lender charges on your outstanding balance
More commonly mortgages are principle and interest loans, meaning your monthly repayments cover both the interest and principal. But in some circumstances, an interest only loan may be more beneficial to the borrower.
What is an interest only loan?
When you take out an interest only home loan with your lender for an agreed period of time (for example 5 years of a 30 year loan), your repayments only cover the interest on the amount you borrowed. This means your repayments will be lower during the interest only period, which could help you save more money to purchase another property or pay off other more expensive debts.
The catch? Your loan balance won’t reduce as you’re paying nothing off the amount you borrowed. You don’t ‘own’ any more of the property than you did at the beginning of the interest only period. For investors, this means you need to rely on capital growth to build your equity. Depending on how the property market is performing, if the capital growth doesn’t cover the cost of selling you could face a net loss.
At the end of the interest only period, your loan will change to a principal and interest loan which means higher repayments. This can be a big shock to the budget.
Interest only loans may or may not be the right fit for you. Your first step should be to speak to our mortgage specialist Paul about your individual needs and objectives when financing your investment property.
Using an interest only loan to invest in property
For some property investors, an interest only loan is great at tax time. The interest repayments can sometimes be offset against rental income and other eligible property costs, making it a smart way to maximise your tax deductions and cash flow.
“For property investors, interest on an investment property loan can typically be deducted against the income earned from the property. This creates a tax deduction that may result in lower tax or even a refund,” Kudos Money accounting partner Trudi Cowan from TCK Accountants explains.
Interest only repayments can also benefit investors who also have a home loan on an owner occupied which isn’t tax deductible. They are able to use the cash they are saving from not paying principal on their investment property to reduce the non-deductible debt.
Kudos Property Investor Case Study
We recently helped a client refinance both their owner occupied and interest only investment loans totalling $1,030,000. We were able to get them a better interest rate on both loans, as well as switch their investment loan from principal and interest to interest only, saving them a huge $1,803.53 in repayments per month.
Their strategy now is to use their monthly saving as additional repayments to their owner occupied loan. This will allow them to pay off their home loan within 9 years and 11 months instead of the 18 years and 1 month left on their current loan. This will save them a huge $78,761 in interest.
Once the home loan is paid off, they can redirect the $4,521.21 repayments they were making on the owner occupier loan to the investment property. Their investment loan will be paid off in 23 years and 1 month, nearly 5 years sooner than if they remained in their current loan, saving them $62,068 in interest.
The amazing thing about this scenario is they aren’t spending any more money on additional repayments than before they refinanced. They are just allocating their funds to pay off their home loan first and taking advantage of the tax benefits of an interest only investment property loan.
“When you have both an owner occupied loan and an investment property loan, there is a greater benefit in paying down the owner occupied loan first as there are no tax deductions available on the interest associated with this loan. It makes sense to take advantage of making interest only repayments you can deduct from your tax bill, and pay down the owner occupied loan that is non-deductable first,” says Trudi.
“If you are planning on turning your current owner occupied home into an investment property in the future or are paying more than the minimum on an investment loan, we also advise the use of offset accounts. Rather than paying into the loan directly, the surplus is stored in loan redraw. We recommend this because redrawing off your mortgage can create mixed purpose loans for tax, making things messy quickly if you decide you want to use the funds for a different purpose later on.”
Interest only loans are not the right fit for everyone. Seeking appropriate advice from a financial advisor or accountant and an experienced mortgage broker is paramount when deciding on the best loan for your investment property. Speak to our mortgage specialist Paul about financing your investment property today!
*This article is not classified as certified tax advice.
You should seek independent advice from your tax practitioner and if you’re looking for a trusted advisor contact us for our recommendations.