Money Loan Matters: Principal and Interest Vs Interest-Only Payments
Mortgage interest rates in Australia are at an all-time low. Even so, a recent study revealed that seven out of 10 Australian households are having trouble meeting their monthly mortgage repayments.
As investors, it’s crucial that we wisely manage both our cash flow and debt levels. There are a lot of varying opinions regarding which loan payment options best accomplish this objective.
This topic is often hotly argued about in media opinion pieces relating to property investing, mortgages and the finance industry in general. For the most part, the pros and cons both sides of the argument present are accurate, but they are irrelevant because they do not take into account all the various considerations, including the personal circumstances that go into designing an effective loan structure.
Interest-Only Payments: The Pros and Cons
To start with, let’s have a look at what most people believe are the benefits of the interest-only option:
- Lower Monthly Payments: Because you are paying only the interest component on your home loan, your monthly payment will be comparatively lower
- May Maximize Tax Deductions: If the loan is for investment purposes, then the interest you pay on it could potentially be tax deductible.
The commonly-claimed disadvantages of interest-only loans include:
- Availability: Interest-only loans are not available from every lender, even for investors.
- Higher Interest Rates: You will want to shop around, but many lenders charge higher interest rates for interest-only loans.
- Affordability: You will need to pay off the loan at some point. When the loan reverts to a principal and interest (P&I) loan, the repayments usually rise, so there is a concern regarding affordability.
- Falling Value: If the property falls in value, you may end up owing more than the property is worth because the outstanding loan amount may exceed the value of the property.
- Changing Rates: Interest rates are currently low, so while there is no guarantee that they won’t go even lower, this means now is a good time to pay off some of the home loan principal, just in case rates rise in the future.
- Temptation: Lower repayments could tempt you to spend more money than you can really afford.
Designing a Loan Structure: Key Factors to Consider
Before addressing these points in turn, let’s digress and consider which factors are the most important in designing a loan structure. Here are the three main factors that are non-negotiable:
- The loan must provide the quantum of money you need.
- It must be possible to choose which debt you pay off first.
- The loan should not require cross collaterisation.
These factors will dictate what features you require from a loan product to allow for optimising your loan structure, including the importance of an interest-only option. You need to address these factors first before considering interest rate and fees.
Next, you need to address these factors in the context of cost. To most people this is a subject of interest rate and/or fees, but cost is far more complex than this. These factors determine the before-tax costs of a loan, but we live in a society where we are required to pay income tax, so real cash costs must be determined in after-tax dollars in order to make an informed decision.
This is where the flexibility to choose which loan to pay off first becomes most important, because for most investors personal debt is far more expensive after tax than investment debts.
You also cannot properly address cost without considering opportunity cost. We all have finite resources and borrowing capacity, so every time you make a purchase or take out a loan you give up the opportunity to spend capital and/or debt on something else. This includes paying down loans or simply accumulating money, not just buying new investments or using the money to fund personal consumption.
When making an investment decision, you need to think about how much of your own money you wish to contribute and/or how much debt you want to incur. In cases where a lender will not provide the level of debt you have budgeted when making your investment decision, you should consider whether it is better to provide more funds from elsewhere, or to use an alternative lender.
The immediate loss of control of capital, through making principal repayments, also comes with an opportunity cost. You can use any available funds immediately, while accessing capital tied up in equity requires a finance application with all the associated time and hassle, as well as further exposing you to risks relating to changes in lending policies and valuations. Cross collaterisation is not an immediate issue, but it also exposes you to the same risks relating to lending policies and valuations, with no gain to yourself.
Now let’s go back to the pros and cons of interest-only loans and consider them in the context of creating a robust and efficient loan structure. The pros that are most commonly mentioned are unambiguously true, and the cons are less so:
Some Do, Some Don’t: It is true that some lenders do not offer an interest-only option, but most do. This is a good way to filter out some lenders, and not to change your proposed loan structure.- Check Premiums: Many lenders charge a premium for interest-only loans, which is yet another factor in your choice of lender, as is the headline rate itself, but it should be one of your final considerations.
- Understanding How Loans Work: The other stated cons are all related and brought up because most people, including industry commentators, lack a basic knowledge of how loans work. There is a big difference between choosing to pay interest-only and not paying down the loan. The existence of Offset Accounts and Lines of Credit (LOC) mean you do not have to pay more interest on a loan if you accumulate cash and choose not to pay down a loan balance. Paying down the principal of a loan simply reduces your access to cash, it does not save you money and does not change your risk profile
Some Do, Some Don’t: It is true that some lenders do not offer an interest-only option, but most do. This is a good way to filter out some lenders, and not to change your proposed loan structure.Offset Accounts and LOC Help
Those of you who do not understand how Offset Accounts and/or LOC’s work please feel free to contact me directly by filling out the linked form for a no obligation, free consultation. This topic is important and you are probably costing yourself money needlessly, or you will, if you do not have a basic understanding of how different loans and features work.
There are reasons why someone might choose to pay principal and interest. For example, if there is an interest rate saving that outweighs their requirement for available cash, or if they believe that they will spend any cash that remains available.
Servicing may also be an issue because lenders frequently use shorter amortisation periods when considering interest only applications. This increases theoretical repayments in their calculations and can affect the amount you are able to borrow; however, in the vast majority of cases, choosing the interest-only option provides greater utility and flexibility in handling your finances and, where there are loans with different after-tax costs, some real savings.
Comments
Got something to say? Post a comment...
You must be logged in to post a comment.
Paying down the principal of a loan simply reduces your access to cash, it does not save you money and does not change your risk profile. Alistair, can you unpack this a bit more, because I must be old school. I thought that paying down the principal of a loan (on my personal home), was paying back the loan and that’s how I end up owning my property outright. The fastest I do this, the less interest I pay. So I’m a bit confused!
Hi TeamVAT,
I think I know where Alistair is heading… Let’s break it down a bit:-
“Paying down the principal of a loan simply reduces your access to cash…..”
– you would likely agree with that bit, wouldn’t you? You are replacing the Equity you have in cash with Equity you hold in the house value.
Cash is way more useful, and more readily utilised – whereas Equity in a house often requires taking out a loan again to turn it “back into cash” if needed. If lending became more restricted (e.g. GFC times) and you wanted your money back, would you get it all?
Thus, having cash is much more flexible.
“…. it does not save you money and does not change your risk profile.”
That first bit about saving money should be considered in the context of the alternatives e.g. If you didn’t pay it off the Principal, did you nevertheless “save it” in some other way? An Offset Account allows you to hold cash, while also saving Interest paid – arguably BETTER than paying down the loan, as you retain the cash, thus retaining flexibility.
If saving in an Offset, versus paying off a Loan, your nett position can be every bit as good as if the Loan was repaid (read the post here – https://www.propertyinvesting.com/topic/4410311-the-true-power-of-an-offset-account/ ) and even BETTER given the flexibility you retain.
If any Principal repayments were “Saved” in the Offset Account, you could CHOOSE to use it to pay down the loan at any time. BUT, if you later turned your “old PPOR into an IP”, you would want to retain the WHOLE mortgage, without having had Principal paid off. So softly, softly – use an Offset and sleep well. ;)
And the “risk profile” bit – well, whether you hold Equity in Cash or in excess value above a mortgage, your nett “Assets vs Liabilities” is unchanged, yes?
Benny
Benny has probably articulated my point better than I could have. There are tax structuring issues that also need to be considered when choosing where to place cash, but paying down the principal of a loan saves no more money in interest payments than paying the cash into an offset, redraw or a LOC. It does limit your access to that money though. For some people, those who spend whatever is available, P&I is a good option but that is a behavioural reason, not a financial one.
Great article Alistair, always good to know the pros and cons on these 2 loan types and examples/tips goes along way to ones interests in applying.
@Benny, thanks for the explanation and link, very useful and valuable information.
cheers
zen
If people cant afford their mortgage at these rates then there will be a bloodbath in Australia in 2018-2020 when rates go up……
What makes you so certain that rates will go up within this timeframe? I don’t disagree with you that there will be a lot of people in trouble if rates do go up, but this isn’t a given. I’d also be interested if you could explain the relevance of your comment to this article.