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Principal & Interest or Interest Only

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Transcript

Principal and interest or interest only? When considering your finances, it is the backbone of buying property. Now, I’m just going to go through a couple of reasons why people keep talking about interest only versus principal and interest. Simply put, what’s the difference? In interest only, your repayment that goes to the bank is only to cover the interest of the loan. It means that your balance is actually not coming down. Now, principal and interest means you’re not only paying the interest for the loan, but you’re paying a small portion on top of that to bring your balance down over the contracted loan term. The common contracted loan term is 30 years, so that small balance each year represents 30 years of paying it down to bring it to zero.


So why one or the other? Now, in previous years, you would say interest only everything, and there’s a reason why. Number one is rolling over interest only when it expires was literally a tick of a button. Tell the bank, “Keep it up another interest-only term.” Or, refinance it and the banks would look at it from an interest-only lending point of view. Now, don’t get me wrong. That had its pros, but it also had its cons, if you look at it in today’s world. Looking at it from today’s world, the thing to consider is policies have changed, so when you had an interest-only loan finish up, you’d actually now need to consider can this person do another term of interest only, assuming that they can pay it on principal and interest by the time that loan term finishes?

For example, if you’ve got a 30-year loan term, and then with that 30-year loan term, you have interest-only for three years. The banks may look at your repayments based on a 27-year loan term. Why? Because technically, their interest only doesn’t last forever. Now, there are some alternate banks that can give you some unique scenarios where they actually consider you interest only, but what that means is that comes at a cost, usually at some sort of extra fee, some sort of extra interest rate, or something else.

So, now that these policies have changed, where does that put you? What do you do? Now, it’s important to speak to certain advisors, maybe your broker, your accountant, and so forth, who might be able to go through deeper pros and cons for tax and other scenarios, but I’m going to give you my own thoughts just over here.

Firstly, if you’re keeping interest only, that may mean you have to start resorting to banks that are alternate lenders, that provide different ways to measure your expense over income and your borrowing capacity, and it also means that you might be limiting your borrowing capacity, because when going with those banks, sure, you might get that same amount, or an increased amount, but then you have those cons of extra costs. Now, when you’re using other banks, you might limit your borrowing capacity because of the interest only.

If you’re looking at the actual phase of your property journey, if you’re in an acquisition phase, basically acquiring more properties, really trying to build the asset base, then going on interest only may reduce your chances of doing that, or it may mean you have to go to an alternate lender sooner than you had to, therefore increasing your costs of the property that you own, whereas if you kept it principal and interest to begin with, well, you’re maximizing your borrowing capacity and lowering costs, and you’re likely to be staying with your major and second-tier lenders, which means your cost for the interest might not be as much.

So at the start, you might be doing that, but then you might get to the point where these alternate lenders are better for improving your borrowing capacity, and you might shift to them. Now, when you shift to them, that interest only and principal might not make any difference, or it might make a difference that improves your borrowing capacity, so that could be where you might be thinking from an acquisition phase.

Now, coming back to the pros and cons or versus each other, why would someone not go principal and interest is another question. If you’re not going to principal and interest, that’s basically thinking around, “Okay, interest only is giving me some advantages. What are those advantages?” Well, you’re paying less of a repayment, so to own this portfolio, it’s actually costing you less. It might be costing you more over the longer term in interest, but costing you less out of pocket to keep that property afloat. Why people do that is because whilst they’re keeping less in terms of their payments, they’re able to save more, or buy more properties, or they’re able to see through the cycle as the rent increases and the values of the property increases. Then, when you think about that debt, it doesn’t look so bad now, because you might have bought here, but then a couple years later of interest only, you might be sitting here.

So that’s some of the key strategies. Now, also, someone might say, “Well, on principal and interest, Arjun, your tax that you can claim actually is coming down, because the loan balance is coming down, which also is there.” Now, some accountants believe the tax deduction is the most important part. Some accountants believe claim what you can, but having no expense might be better than having an expense, because you never get all of the money back. You just get a tax deduction, right?

So, when you’re considering interest only and principal and interest, there are so many pros and cons of these two considerations, but when you discuss this with your broker or your banker, really weigh up what the end impact to your borrowing capacity is. Combine that with are you okay to feel the shock of that repayment change. Can you have a plan B for that repayment change on interest only? And, are you okay on the other side, with principal and interest, and paying that extra at the starting part of your investment journey.

These are some of the pros and cons to consider, and when going through that journey, you’ll also have to put in your life stage. Are you a acquisition phase, buying lots of properties, adding on, maximizing your borrowing capacity, or are you starting to wind down? Because that will also help you decide. That’s it from us at InvestorKit, the experts in wealth creation, helping you take action.