As the name suggests, an interest-only loan is one in which the payments made by the borrower to the lender include only the interest that has accrued on the loan.
To give a simple example: if a borrower borrows $100,000 at 6% per year, and is obliged to make one repayment a year (this is an illustrative example), then the amount paid to the lender will be $6,000.
Interest-only loans contrast to principal and interest loans (“P&I”), in which the periodic payments include an amount of repayment of the initial amount borrowed, which is called the principal.
With an interest-only loan, at the end of the loan period, the amount borrowed is the same as it was at the commencement of the loan period. The borrower has simply serviced the loan.
Interest-only loans are often used when the amount borrowed is used to purchase investment assets. By making these ‘investment loans’ interest-only, the borrower avoids having to use cash flow to make loan repayments on debt that is giving rise to tax-deductible interest. Accordingly, ignoring changes in interest rates, the amount of tax-deductible interest does not reduce over time.
1) Allows you to pay off non-deductible debt first
Structuring your investment debt as interest-only allows you to firstly focus on paying down the more expensive, non-deductible debt such as your family home (PPR) debt, or car loan debt.
Because the interest on your ‘own-home’ debt is not tax-deductible, private (non-deductible) debt is effectively more expensive than investment debt and should be paid off first, leaving any deductible investment purpose loans to be paid off later.
So, by preferring to repay the expensive debt, the borrower reduces the effective amount of interest paid overall.
By not repaying the principal amount of the investment debt, the borrower ‘frees-up’ cash flow to be used for some other purpose. This may include the repayment of other loans which were not taken out for investment purposes, such as the family home, credit cards, school fees, or car loans.
ASIC tells us that 2 out of every 3 investment loans is interest-only, while 25% of owner-occupied loans are interest-only. You can read more about interest-only loans on the ASIC website.
2) Allows Capital Growth to do the work for you
Interest-only loans are also used where borrowers expect the capital value of the purchased asset to increase over time. To give a very simple example: suppose a borrower borrows $100,000 as an interest-only loan and uses it to buy units in a managed fund. The loan term is five years. After five years, the managed funds have increased in value to $130,000. The borrower sells $100,000 of the units in the managed fund, uses it to repay the debt and is left with an asset valued at $30,000. The same works with property, shares, and businesses.
Of course, there is a danger that the asset will not rise in value – but this is a risk of all investment borrowing and is not specific to interest-only loans.
Indeed, where interest-only loans reduce the amount of after-tax interest being paid on all of the borrower’s loans, they can actually serve to reduce the overall risk to the borrower. The total cost of the debt is reduced, meaning that the amount by which assets need to increase in value so as to justify the decision to borrow to invest is lessened.
Interest-only loans are also sometimes used by borrowers who use the debt for private purposes, such as a home loan. This is usually done to maximise cash flow. For example, a family in the high-cost years of raising children might change their home loan to interest-only so as to ‘free-up’ as much cash as possible for daily living expenses.
3) An Interest Only loan allows you to maximise cashflow and tax deductions
Another common purpose is where a borrower makes their loans interest only, and uses the money that would otherwise have been dedicated to repaying principal to finance extra superannuation contributions.
The plan is usually for the superannuation contributions to be withdrawn later in life and used to repay the loan. This can make sense because the superannuation contribution is only taxed at 15%, whereas the income may be taxed at a higher rate in the borrower’s personal hands.
So, for every $1 of pre-tax earnings, the borrower can repay more debt if the $1 passes through their superannuation fund rather than their own hands.
4) Whats the Conclusion?
- If you are investing or constructing a home, an interest-only loan is usually the most optimum way to structure your debt
- Many interest-only periods last for 1-5 years, and sometimes up to 10 years
- Princpal repayments will start after the interest-only period ends
- You can extend the interest-only period again, via the same lender or a new lender. But, your financials still need to be in good shape, with continued good income and equity
- Structuring a loan as interest only will make it more manageable and improve your cashflow
Speak with one of our specialist mortgage brokers by giving us a call on 1300 733 942 or by filling in our online enquiry form to find out if you qualify with one of our 40 lenders.