The only time interest only repayments make sense

For years, whenever I sat down with a client to discuss loan repayments, a general rule of thumb was always applied...

if the property was owner occupied, it was best to have principal and interest repayments as the interest attached to the loan was non-deductible. 

Likewise, if the property was an investment, usually interest only repayments would apply as the interest is tax deductible so it made sense to focus on paying down your non-deductible debt first.

Rates for both options were the same so that was about as much thought as most people would give it.

However, since APRA introduced their measurements in late 2014 to assist with normalising the housing market, more thought now needs to be given as to whether someone should have principal and interest repayments or interest only repayments.

I’m sure you’re now aware that interest only loans now come with a higher interest rate compared to principal and interest.

For the most part, I now take the view that all loans need to be paid down eventually, so if you’re incentivised with a lower interest rate, it makes sense to opt for principal and interest repayments.

However, there is one time I will always instruct my clients to go for interest only repayments – cash out loans.

WHAT IS A CASH OUT LOAN?

Let’s say you own an owner occupied property and after a few years you’ve paid a bit of your mortgage off and the property has increased in value.

If you were looking to purchase an investment property, one option would be to access the improved equity by obtaining a new loan, secured against your owner occupied property.

This loan would serve as the deposit plus costs for your investment property and then another loan would be obtained and secured against the investment property.

From a finance perspective, what I would do is two applications, one for the new loan against your owner occupied property and the other a pre-approval for the new investment property.

When applying for these two loans, it’s important to have the new loan against your owner occupied to settle before you find the investment property as you’ll need to use this money to pay for the 10% deposit.

The question is, what do you do with the new money the bank has given you?

My advice, is to stick it into the redraw facility of your new loan so that the balance is zero and then make your loan repayments interest only.

Then once you’ve found your investment property you can pull the deposit plus costs out from redraw and at that stage I often discuss switching the loan to principal and interest.

The reason why I advise interest only repayments at the start is because in my experience, it generally takes 4-8 months to find a suitable property.

The repayment amount for interest only repayments is determined based on what the balance of the funds are. In this case, if the loan balance is zero there’ll be no repayments associated with the new loan while you’re out looking for your investment property.

If the new loan was principal and interest, repayments are based on the original loan limit. As such, if the balance is zero what will happen is every repayment will be a pure principal payment, chopping down the overall limit of the loan with every repayment. Depending on how long it takes for you to find your investment property, this could seriously reduce the amount of funds you have available.

In summary, if you’re applying for a cash out loan and you don’t have an immediate need for the money, best thing to do is have your repayments interest only so your cash flow is unaffected. Once you’ve used the money, I would then suggest you consider switching back to principal and interest in order to obtain a lower interest rate.

Kind regards,

Tim Russell