Best type of loan for an investment property

If you are looking to invest in property, you may need to consider a different type of loan than an owner occupier loan.

Here’s a helpful guide to the different options you have as a property investor.

What are your options?

When applying for an investor home loan, there are two main options: Interest-only loans and Principal and Interest home loans.

Interest-only investment loan

Interest-only (IO) loans are home loans that delay the repayment of the borrowed amount (the ‘principal’) for a fixed term, usually between three and five years. During this time, you only have to pay the interest on your loan, not the principal. At the end of that set period, the repayments transition to paying off the principal as well as the interest, to what is known as principal and interest (P&I) repayments.

An interest-only loan term is usually the same length as a standard home loan – around 30 years. However, instead of paying principal and interest for the full 30 years, you have the option to pay just interest for the first five years, for example, and then pay substantially more for the remaining 25 years.

Interest-only home loans could be summed up as ‘less now’ but ‘more later’ in terms of the monthly repayments one has to make across the term of the loan.

Interest-only loan pros

• Lower repayments: The temporary lower repayments of an interest-only loan can free up money for other expenses like renovations or paying off other outstanding debts.

• Investment Strategy: Interest-only loans are great for investors who plan to profit by selling their properties within the IO period (eg. after making a capital gain) because it reduces their expenses (and relative cash outflows).

• Buying time: The reduced repayments effectively let people buy time through the delaying of higher repayments. Whether it be a temporary reduction of income (eg. someone taking 2 years off to study) or a temporary increase in expenses (eg. 2 years of higher school fees), if borrowers are confident of returning back to a level of income or expense ‘normality’ at the end of the interest-only term, then interest-only loans are a great way for them to effectively buy time and flexibility.

Interest-only loan cons

• Higher interest costs overall: Since you’re not paying off the principal over the interest-only period, you’ll end up paying more interest over the life of your loan than someone who has been paying both principal and interest over the entirety of theirs.

• Higher interest rates (generally): Interest-only loans often have a higher rate of interest than principal & interest (P&I) loans. This isn’t the case for all lenders though.

• Repayment shock upon expiry: If you’re not prepared, the expiry of an interest-only period can come as a shock as the costs of repayments suddenly increase.

• Less equity: By only paying the interest portion of your repayments, you’re possibly (subject to property value movements) not building any equity in your property. Many investors in recent times have built equity through rises in the value of their properties, but if the value falls, you could end up owing more to the lender than what the property could actually sell for if indeed you were forced to sell the property.

Principal and Interest Loan

The term ‘principal and interest’ (P&I) refers to two components of your home loan repayments:

• The principal, which is the initial amount you’ve borrowed for the loan

• The interest, which is the cost charged by the bank to borrow the money

So if you borrowed $400,000 for a home loan at a 3.00% p.a. interest rate, that $400,000 is the principal which you have to pay back, while the interest is what you pay back on top of that principal (3.00% per annum on the balance owing).

With each principal & interest repayment, an increasing portion of the payment will go towards paying off the principal and a decreasing portion will go towards paying interest, since you’re chipping away at the balance owing right from the beginning.

The key difference between principal and interest repayments and interest-only repayments is principal and interest loans pay off the actual loan principal right from the beginning. So the actual house you’ve borrowed all that money for is being slowly paid off, whereas interest-only loans only pay the extra interest costs.

Why are interest only loans popular amongst investors?

Interest-only loans can be a good short-term solution for property investors and owner-occupiers alike, but they're generally more suitable for investors. This is because investors can claim the interest portion of their loan as an investment expense on their tax returns.

According to the ATO:

“If you take out a loan to purchase a rental property, you can claim a deduction for the interest charged on the loan or a portion of the interest. However, the property must be rented out or genuinely available for rent in the income year you claim a deduction.”

That means investors can claim their entire repayments if they use an interest-only loan, making them a very affordable short-term option for building a portfolio.

However it’s important to remember that you will have to make principal repayments at some point down the track, regardless of the type of property. Interest-only loans tend to have more benefits for property investors, while owner-occupiers (outside of what might be described as extraordinary circumstances) are generally better suited towards a standard principal and interest loan. Do your research and read the terms and conditions before making a purchase decision.

What is line of credit?

A line of credit loan means a certain credit amount is approved based on your usable equity.

You only pay interest on what you spend. You can apply for an equity release, but if you’re not ready to use the funds right now, ensure you have an offset sub-account so you won’t pay interest on the loan increase until you use the funds.

If you take out a lump sum, you'll pay interest on the entire amount. With a line of credit, you only pay interest on the amount used, but you could be tempted to access this money for unnecessary luxuries.

Being transparent

It's very important not to misrepresent your intentions for a property when applying for a home loan.

The differences in rates come down to the amount of risk that tends to accompany each type of home loan. With investment properties, there tends to be a greater chance of default, and therefore more exposure for the lender, among other factors.

No matter what type of loan you require, the same tried-and-true tips apply: pay down your existing debts, improve your credit score, and show you can pay off a mortgage.

If you’re ready to move into your investment property, or turn your home into an investment, speak with one of our lending specialists today to talk about refinancing.

If you are thinking about investing, don’t hesitate to contact our helpful team online or over the phone.

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