What’s the difference between principal and interest and interest-only repayments?
Principal and Interest (P+I or P and I) repayments are payments on a loan that covers the interest portion plus an extra amount to reduce the principal or amount owing. Most commonly, owner-occupied use such a repayment to pay their home loans. Over time, this will ‘pay off’ the mortgage.
Interest-only repayments are payments on a loan the only covers the interest portion. Most commonly, investors use such a repayment to pay their investment loans. This is due to the interest repayments on an investment property are tax-deductible. An interest-only period often lasts 2 years. However, it can be as long as 5 years before returning to a P+I repayment structure.
Should I choose a principal and interest loan or interest-only loan?
P+I loans make repayments large enough to reduce the principal over time. This means that after the loan term the amount owing will be $0. For the vast majority of people looking to purchase an owner-occupied property, P+I repayments make the most sense.
Investment properties are the main point of indecision of whether it is better to choose P+I or interest-only repayments. On the one hand, P+I repayments allow you to own the property after the loan but require greater monthly repayments. On the other hand, interest-only repayments are smaller. But, at the end of the interest-only term, you don’t own any more of the property than at the beginning.
Principal and interest loan
The major benefit of P+I repayment structure for investment properties is that over time you are increasing equity in the investment property. After the term of the loan, you will own 100% of the property.
Interest-only loan
The primary benefit of an interest-only home loan is the tax-deductibility of interest repayments. By not paying down the principal, the interest repayments stay at their initial level. Hence, enabling large tax-deductible payments over the course of a financial year. This can reduce your marginal and average tax rate. So, you retain more of the money you earned in the financial year. This is the basis for negative and positive gearing and why they’ve been so popular in Australia.
Moreover, interest-only home loans allow you to pay off the principal of another debt, which has a higher interest rate but lower repayment period. However, you should speak with a financial advisor before engaging in an interest-only loan, with other debts to repay.
Another reason why a borrower may choose an interest-only loan is for cashflow reasons. Due to the lower repayment period, cashflows have an increased flexibility and discretion for other areas. These areas include other investments, lifestyle or other objectives.
Borrowers may also elect for interest-only loans due to changes in personal or financial circumstances. Such changes include sudden health complications, COVID-19 and the reduced rental income or a divorce/separation. As so, this gives the borrowers some added time of reduced repayments to lessen the burden of other expenses or difficulties that may be facing.
Principal and interest rates vs interest-only interest rates
If opting for an interest-only term, the interest rate charged is often higher than that of a P+I repayment plan. This is because the bank assumes that once the interest-only term is approaching conclusion, that the borrower will refinance and ‘restart’ the interest-only term. This delays the payback period for the banks and hence increases their risk.
Where can I get interest-only loans in Australia?
Almost all Australian lenders including the big banks offer interest-only loans. Simply speak to a bank, financial advisor or mortgage broker. As such, you can begin determining whether an interest-only loan is an appropriate option for you, according to your own personal and financial circumstances.
On investment properties, you can apply for up to 2 5-year interest-only terms, whereas on owner-occupied properties you may only apply for 1. Beyond this, the difficulty of getting approval for an interest-only loan has increased as a result of increased scrutiny and eligibility requirements requested by the regulating bodies such as ASIC and their updated policies such as the National Consumer Credit Protection Act (NCCP).
Should I do an interest-only and save up for another investment property or pay off the debt?
An interest-only loan with lower repayments may allow a borrower to save enough money for a deposit on a new property. This may be a useful strategy in increasing the rental income from one property to two properties. The limiting factor for this strategy is borrowing capacity. Some lenders may believe that the borrower is already fully extended and will not accept the risk of lending further funds. We encourage you to speak to a financial advisor to help decide if an interest-only loan, for this reason, is right for you. This is because you may already be fully extended or maybe approaching key milestones such as retirement which may limit borrowing capacity.
COVID-19 Interest rate freeze
During COVID-19 banks have allowed people to ‘freeze’ interest repayments and instead have been adding them onto the principal. Some banks then include the total amount owing in calculating interest while others only consider the principal owing before the repayment freeze for interest re-calculations. It’s best to speak to a financial advisor or the bank you’re currently dealing with to obtain further information to determine if this is right for you. In this scenario, neither P+I or interest-only home loans require any payment. This can help people during COVID-19 who may have reduced income to redistribute their income to pay-off more urgent debts, bills or lifestyle objectives.
What is positive and negative gearing?
Positive gearing is where the rental income on an investment property is greater than the sum total of interest repayments over a financial year. This makes the majority of income earned through the rental property is essentially tax-free. This is because you are paying the tax-deductible interest payments with the rent income. The small remainder of income is taxed at your marginal tax rate. Profit earned by investors who positively gear has 2 components; rental yield and the capital appreciation of the property or the increase in property value. Some investors elect to positively gear in an attempt to maximise rental yield over a number of properties. Other investors rely on the increase in property value over the duration of the interest-only term.
Negative gearing is very similar except the rental income on an investment property is less than the sum total of interest repayments over a financial year. This means that the entirety of the rental income earned is essentially tax-free under the same reasons outlined in positive gearing, but in addition, a portion of your PAYG income is also used to repay interest and hence is tax-deductible. Negative gearing has the potential to generate greater returns than positive gearing but also comes with greater risk. Negative gearing results in a property with a greater value than that of positive gearing. This means that any percentage increase or decrease in housing prices has an increased effect on the return in dollars.
Summary
Interest-only mortgages are only suggested to be used for investment properties as a tool for tax deductions. Beyond this, a principal and interest repayment structure is advised as it increases your equity in the property. This has added benefits in some cases, such as redraw and offset facilities. These features can assist you with reducing the costs of your loan.
Disclaimer: The information contained in this blog is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial advisor.
