Interest Only versus Principal & Interest Loans – which is best?
With a recent increase in the uptake of Interest Only loans we are pondering the question of which type of loan is best? Interest Only or Principal & Interest?
People are taking on Interest Only loans in order to free up their cash flow, to ensure a certain standard of living is maintained and in an attempt to save but you need to keep in mind that this type of loan is exactly as it sounds: you are not paying off any of the principal of the loan – if the market (or circumstances) change and you need to refinance you could find yourself in a position of negative equity.
With historic low interest rates many are asking us which type of loan is best to adopt – on face value paying P&I makes sense when interest rates are low as it allows you to repay the loan faster. But, there are situations when IO might just be the better strategy. Confused? You’re not alone so let’s look firstly at how they both work.
Interest Only
With an Interest Only (IO) loan you are only required to repay the interest portion, as well as any fees, over the predetermined IO period offered from the lender. When the original IO period expires (typically from 1-10 years) then you must renegotiate a new IO term (if desired). To make sure you are not caught out, it’s imperative that you know exactly what your particular lender allows at the end of the IO term, before it happens.
Principal & Interest
Principal & Interest (P&I) loans are designed to repay your loan over the defined loan term – usually 30 years. Your lender will calculate your repayments including the interest charged for the repayment period and any loan fees, plus a portion of the principal balance.
Under a P&I loan as your balance reduces, so does the interest component, assuming the interest rate remains constant, meaning your scheduled repayment pays off more of the loan principal, as the loan term progresses.
Using an IO loan
Interest Only loans are particularly popular with investors for several reasons, based largely on the assumption that the property is going to increase in value. Some investors maximise their interest repayments and use the tax deductibility of interest on their loan repayments.
The higher the loan balance and longer the IO period, the more an investor can maximise their tax-deductible benefits.
IO can offer cash flow benefits by freeing up the ‘principal’ component of each repayment for other uses. Lower scheduled repayments allow many people to benefit by accumulating their deposit for their next property purchase. Others take advantage of the opportunity to pay off other non-deductible personal debts such as car loans, credit card debt or personal loans. Critically, this requires a high degree of discipline to ensure the principal is not diverted to other uses. Without this discipline, you could be worse off.
IO may also offer the option for investors to prepay interest for the upcoming financial year, allowing them to claim next financial year’s benefits in the current one. As an incentive, many lenders offer some rate concessions if receiving their interest paid one year in advance!
Another advantage with typical IO arrangements is that many lenders still allow flexibility to make extra repayments. So, when IO is being used as a way of reducing loan repayment amounts, principal reductions can still be made as needed.
Things to be aware of with an IO loan
Increases in cost of living expenses or interest rates during the IO period can mean that, when an IO loan converts to P&I, the resulting repayments could leave you on a much tighter budget or exceeding your ability to pay.
At the end of an IO period, lenders will assess your serviceability on the remaining loan term. So for example, on a 30-year loan, coming off a 5-year IO term leaves you having to repay your debt based on the remaining 25- year term.
Lenders will not rely on any intended asset sale to repay the debt either, even if that’s what you have in mind. You must be able to demonstrate your ability to repay the outstanding loan balance and obviously this will compound for any extended IO periods.
Another potential disadvantage of the IO strategy is being overexposed should the value of your property fall resulting in negative equity. So, although an IO strategy can initially help with serviceability, it is not advisable to enter into IO arrangements for the sole purpose of obtaining a loan higher than you could otherwise afford.
Using a P&I loan
P&I loans can act as a forced method of savings. This may be particularly beneficial when your loan has a redraw option and you have access to any available funds in your loan account.
The main benefit, especially with current low interest rates, is that making repayments off the principal can help you own the asset sooner. If repaying a non-income producing debt like your home loan, it is typically recommended that making principal repayments is the way to achieve this.
The P&I versus IO decision should be part of your wider borrowing strategy and financial plan. As always, we recommend you seek professional advice when planning your financial decisions. Contact the team at Oak to learn more or to have a chat.
