loans types – interest only or fixed?

From Steve’s last newletter:

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Which Loan Is Best For Me – Principal and Interest or Interest Only?
An issue investors must continually re-examine is trying to decide the best way to set up their finances. For example, you need to think about:

What percentage loan-to-valuation ratio (LVR) do you seek?

Do you go for a principal and interest or interest only loan?

How long should your loan be? and

Do you ask for a variable or fixed interest rate?

I’m going to discuss these four issues over the coming months, starting now with the issue whether to seek a principal and interest, or interest-only loan.

Let’s start from scratch and explain a definition for each:

A principal and interest (P&I) loan is one where each repayment is the combined sum of the appropriate interest plus a portion of the original loan amount. The amount of each repayment is calculated as a present value, which is a statistical term where the only way to easily work it out is by using a financial calculator.

On the other hand, an interest-only (IO) loan means that your repayments are simply 100% interest and no principal, which of course means that your loan always stays at the same amount.

Applying these definitions provides two essential differences between P&I and IO loans. These are:

The loan balance at the end of a P&I loan should be less than the loan balance at the beginning. Furthermore, unless there is a loan residual (ie. a balance left at the end of the loan), the amount remaining at the conclusion of the loan should be zero.

Because P&I loans contain a principal component, the repayments should be slightly higher than the IO alternative… well, at least at the beginning of the loan that is.

Let’s look at an example to flesh out the concept.

Bette buys an investment property for $150,000. She has arranged finance at 90% LVR and is given the following choice:

Interest-only loan at a variable interest rate of 6.5% for a term of 10 years. The weekly repayment would be $168.75. The loan after ten years would be $150,000.

Principal and interest loan at a variable interest rate of 6.5% for a term of 10 years. The repayment would be $209.92 per week and the residual or amount owing at the end of ten years would be $104,551.38.

Principal and interest loan at a variable interest rate of 6.5% for a term of 25 years. The repayment would be $209.92 per week and the residual would be $0.

Which loan should Bette choose? The answer is whichever loan brings her closer to her investing goal in the least amount of time within the context of weighing up the risks vs. the rewards.

The interest-only loan has the lowest repayments, yet the debt balance does not reduce. The principal and interest loan repayment is higher, yet the balance owing progressively reduces.

P&I Loans

With the exception of commercial loans (for reasons outlined below), all my loans are on a P&I basis. This is a deliberate choice, because I want to reduce my debt. This in turn has the effect of mitigating my exposure to a rise in interest rates.

Of course, when debt goes down so too does my interest payments, which then increases my cashflow in the long-term.

Perhaps the biggest risen for the choice of adopting principal and interest loans is the teachings of my Grandfather, considered a wise man by many, who said “no-one ever went broke because they owed too little.”

I firmly believe that recycling debt, as opposed to repaying debt, places the investor in dangerous and uncertain waters unless an allowance is made to repay debt at a later date.

Interest-Only Loans

There are some circumstances when it’s perfectly appropriate to select an interest-only loan. An immediate example that comes to mind is one of our commercial properties. The bank would only provide a ten year loan term and gave us the option of either interest-only or P&I.

If we had of chosen P&I then our loan repayments over ten years (on the basis of a zero residual) would have made turned our monthly cashflow from positive to negative because of the substantial principal component.

Instead, what we have done is to allocate or quarantine a potion of our cashflow to repaying debt, but just held this cash in a mortgage offset account rather than applying it against the loan. By doing this we arrive at the same outcome (ie. debt reduction), but just from a different angle.

Knowing Which One To Choose?

A common theme that you’ll see reappearing over the next few newsletters is that you need to let the circumstances of your deal dictate the way you structure your loan within the context of your risk profile and long-term goal.

Just watch out for the mistake of borrowing money and not having a structured plan for repaying it. Where possible I’d advocate that a P&I loan be used in preference to an IO loan since the quicker you repay your borrowings, the less risk you have when interest rates rise and also the higher your cashflow will become as you pay lower and lower interest.
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Fixed rates:
– History tells us you are financially worse off by fixing your rate.
– You may have to pay break costs if you want to increase your loan during the fixed period.
– Limited extra repayments on fixed rate.
– May not have access to redraw in fixed rate.

Variable rates are far more flexible.

Cheers

Stu

Property & Finance News
at http://www.prosolution.com.au