Choosing the right repayment option is one of the most important things to consider when accepting your loan terms.
Most Australians choose the standard principal and interest loan over an interest-only loan repayment, but many don't fully understand the difference between the two.
There are two main parts to the repayment of a loan:
• Principal - the money you originally borrowed
• Interest - the money you pay to keep the loan.
Principal and interest
Be wary if the lender doesn't tell you about your different loan repayment options or if they don't clearly explain the differences.
Some might insinuate a principal and interest loan repayment will be best because they want you to repay the loan in a way most beneficial to them. If you take out a principal and interest loan, you're obliged to start paying down the loan from the first repayment.
Most people assume they're better off making principal and interest repayments because they're immediately paying down their loan and can see the balance reducing each month. Unfortunately they don't realise that unless they make more than the minimum monthly principal and interest repayment required, they can't redraw those principal payments.
As the name suggests, an interest-only loan obligates you to only pay the interest on the balance (eg. the original amount you borrowed less any additional repayments you've made).
As long as the loan remains interest-only it would theoretically never be paid off unless you choose to make additional repayments or sell the property.
The interest-only repayment option may be particularly beneficial to anybody who wants to reduce their repayment obligations or for investors who want to maximise the tax benefits. A 2007 Cannex study revealed one in every 100 home loans approved to owner-occupiers were actually interest-only and this figure has steadily increased since then.
Below is an example of the difference between principal and interest versus interest-only repayment options.
Interest rate: 7.5 per cent
Loan term: 30 years
Principal and interest repayment per month: $2447.25
Interest-only repayment per month: $2187.50
Difference per month: $259.75
Using the example above, you could make the additional repayment of $259.75 each month and redraw the equity from the additional repayments at any time without approval, as long as you have a redraw facility.
For example, after five years of repayments you would have repaid approximately $19,000 of principal. If you have a redraw facility, you could access these funds for a deposit on your next property purchase.
Some borrowers can be concerned they'll never repay the loan, however under an interest-only repayment option you can still make principal payments as well as the interest if you choose to.
This is done by simply making a payment higher than your interest obligation.
Seven advantages of interest-only loans
If you choose to pay smaller repayments than a principal and interest loan you can use the additional cash for investments or any other purpose.
You can also make larger repayments that'll pay off your principal (so in effect you can treat your loan like a standard principal and interest loan which will be entirely paid off over time).
If you choose to repay any principal, the interest-only nature of the loan repayment type actually allows you to preserve a credit limit. If you ever want to redraw money from any extra repayments, you can.
Investment interest-only loans have tax-deductible interest. This gives you the option of maximising the borrowings on your investment property to claim the deductions.
If you also have an owner-occupied home loan where the interest isn't deductible, you can deposit your spare cash into that home loan to reduce the interest you pay.
Interest-only loans can also reduce your monthly repayment commitment, which is quite valuable if your income is sporadic or fluctuating. By investing the money you save in repayments into a higher return than the interest rate on your loan, you can make your money work harder.
Most interest-only loans have an initial period of five to 10 years. If the interest-only period expires and you still wish to retain this repayment option, ask your lender to extend it.
Reproduced in full with permission: Australian Property Investor Interest only versus principal and interest 4 April 2013
Attention: This article is intended to provide general information only. Every attempt has been made to ensure the accuracy of this information at the date of publication. The opinions expressed in this article do not reflect those of DHA, its staff or agents. Property prices are subject to fluctuation. Prospective investors should seek independent advice. DHA will not be liable for any loss, damage, cost or expenses incurred or arising by reason of any person relying on information in this article.