The choice of mortgage product can be a very confusing decision for an investor. In fact, it can also be a costly one if you make the wrong choice.
The types of loans available for investors are generally the same as owner-occupiers, with the obvious difference between products being whether or not you make repayments on the amount you have borrowed.
Resi Home Loans CEO Lisa Montgomery says, “Choosing between an interest-only and principal and interest loan really depends on what goals the investor has set, and how they wish to achieve them”.
“This begins by understanding the virtues of each”.
“Many investors choose an interest only option to reduce the monthly repayment amount and to maximise the tax effectiveness of the debt”, Ms Montgomery says. The tax deductions available are through negative gearing and depreciation.
“Paying a lesser monthly instalment means you have more disposable income to put towards other expenses”, adds Finance Made Easy Director, Tony Bice.
“This could be critical if you already have an owner-occupied home loan, but could also provide you more money to improve the property or allow you to save for another”.
However, investors must choose their investment property carefully when using an interest only loan option, as the strategy relies on strong capital growth to make money.
In a declining property market there is a risk that a property may be worth less at the end of the loan term than what it was originally purchased for. This would compromise your capital gain, the equity in the property and your ability to repay the loan principal.
“Interest-only loans are traditionally more popular among investors who plan to sell the property in the short-term for profit”, says Ms Montgomery.
If you want to build a property portfolio by using equity in an existing property to buy another investment, a principal and interest loan will help you do this.
“When you don’t make any principal repayment the speed with which you obtain equity in a property reduces”, says Destiny Finance Solutions founder Margaret Lomas.
“For investors needing to grow equity to create deposits for more property, this is not an ideal position”.
In fact Ms Lomas suggests, “the deductions lost by choosing a principal and interest loan are much less than the benefits of gaining greater exposure to a growth market as you have the capacity to leverage again, sooner, as you pay off debt”.
“I always ask if you are not going to repay the principal on a loan, what else are you going to do with the money?”
“Parked against your property debt is the best place for it. Waiting until there is enough to redraw for the deposit on that next property”, Ms Lomas adds.
Accelerating your loan repayments is also something to consider, says Ms Montgomery. “By paying more than the standard monthly instalment, you will create even more equity and faster”.
But while the choice of loan is within our control, market conditions are not and these will play a huge role in what loan works for you and when.
The benefit of interest-only loans is clear when interest rates are rising, offering property investors a degree of insulation from excessive repayments that may trigger cash flow problems, advises Mr Bice.
“If market conditions are such that interest rates are higher or that the value of property increases so that it costs more to buy a property, then affordability may dictate that you need to structure your loans an interest only”, he says.
“If rates drop however, you would either keep your instalments at the amount they are or if the loan is currently interest only then revert it to a principal and interest, given repayments should be more affordable”.
In a slow market, the big concern is that interest only loans result in no gained equity, making leveraging harder and the investor is faced with the risk of being in the same net asset position at the end of the year as they were at the beginning.
“But if the market is slow, equity is still gained with principal debt repayment”, Ms Lomas says.
Of course, the property market in Australia is not homogeneous, with each market performing differently to the next growth wise.
“For those investors looking to build a portfolio – natural capital gain in the majority of markets is sluggish”, says Ms Montgomery.
“If you are relying on natural capital gain over the short term to provide you with equity to leverage into your next property purchase – this may not happen quickly”.
Experienced investor Terry Clarke believes interest only loans are for people with good incomes to start building a portfolio, but given current market conditions would opt for a principal and interest loan.
“In fact, with the benefit of hindsight, I would have long term holdings in principal and interest loans”, says Mr Clarke.
Mr Clarke’s strategy has been to use equity in the family home as deposits for his investments - a strategy that has demanded the best rates.
But for Ms Lomas, the logic is simple: “Investors should repay debt no matter the market conditions. If an investor has personal, non- deductible debt, pay this first while keeping deductible debt interest only. Then, as soon as there is no personal debt, start repaying deductible debt”.
“Investors who are on a constant mission of debt repayment amass greater portfolios over time and retire in a more substantial net worth position than those who pay only the interest”, says Ms Lomas.
Each investor is different and their strategy will differ according to their finance options. One thing that is agreed upon however is the use of offset accounts.
“Investors use offset accounts because they allow them to reduce the interest payable on their loan”, says Ms Montgomery.
“For example, if you have a loan of $200,000 and you have $20,000 in a 100% offset account – your interest will only be calculated on $180,000”.
Over a number of years, both the principal and interest on your loan are repaid faster. For Terry Clarke, “offset accounts are handy to have in case of emergency repairs or if large enough, for that bargain property purchase that may come up”.
Another option includes well-structured lines of credit with split accounts, which allow you to reposition any loan equity into a new account for further investing.
“A line of credit or equity line is essentially an interest only loan and often secured by equity in your home or from other investment properties”, says Rate Detective Director, Warren Dworcan.
“It’s a particularly popular option used by investors to purchase multiple investment properties because you have immediate access to a large sum of money and repayments can be flexible”.
“Let’s say a line of credit for $200,000 has been approved. This means that a total of $200,000 can be used all at once or in smaller amounts, but interest would only be charged on the actual amount accessed”.
Despite the benefits, lines of credit may not suit every investment strategy, particularly if you lack discipline and lose control of your finances.
“If there is equity within the facility, the temptation might exist to draw funds out for personal purposes in the hope that they will be repaid down the track. Apart from the obvious risks with this kind of decision, it may also create significant confusion when it comes time to file your tax return”, advises Dworcan.
“Another alternative is to purchase multiple investment properties using completely separate, stand-alone loans for each property – and even different lenders. Instead of using your PPR as security, you instead take out an equity loan against the balance and use this as part of your deposit, or even a second mortgage on the property. These methods are often employed by far more experienced investors”.
As with any loan, it is advisable to discuss your circumstances with a professional to determine if it is in fact the best option for you.