Key Considerations - The Rising Cost of Interest Only and Investment Loans
It is important to be aware that if you have investment debt, you will be paying higher interest rates than for owner occupier debt.
This used to be the case 15 - 20 years ago, where the difference between investment and owner occupied loans was greater than it is currently.
In fact, it was around one per cent apart…for example; if you could obtain a home loan at 5%, your investment loan would be around 6%.
As lender competition and the number of mortgage brokers increased, the tug of war for business grew and in attempting to grow market share the difference in borrowing costs between investment loans and home loans reduced to the point that the cost was on par.
Recently lenders have reverted back to an increased cost for investment loans and interest only loans when compared to principal and interest loans.
The difference is around 10 to 50 basis points depending on the particular lender (for example 4.20% versus 4.40% is a difference of 20 basis points).
It is probable that unless the property market begins to plateau this gap could stretch back out to 100 basis points or 1 percentage point on your investment interest rate.
The government’s regulatory platform to slow down investment borrowing in the attempt to cap investment lending growth at 10% has the following objectives:
• reduce the number of investment property buyers • increase the number of home buyers • negate property price growth in Sydney and Melbourne
Under regulatory pressure lenders have increased their serviceability requirements to access investment and interest only loans.
This means if three months ago you could borrow $600,000 you may now only be able to borrow $500,000 in the same situation with banks and mainstream lenders.
Below are some key considerations for determining whether to select an interest only repayment and you should always base your decision on your long-term plan and mortgage strategy.
Pro's • Maximise your cash savings: Interest only repayments are lower than principle and interest repayments.
This means that you have more surplus money in your pocket each month that you can place into your loan or an offset account and you can build your cash savings buffer more rapidly thereby assisting with risk management.
For example, should you have any unexpected expenses or in the event of reduced income for a period this can allow extra time to make decisions that suit you.
• Maximise tax deductions: If you have tax-deductible debt you can select interest only to focus all surplus cash flow towards reducing non-deductible debt.
• Enhanced flexibility in your repayments: Your minimum monthly commitment is less than if you selected principal and interest which can provide for greater flexibility.
• You still have the same ability to pay extra off your loan: With variable rate interest only loans you are still able to pay down the principal of your loan either directly into the loan account or via your offset account.
• Optimise your ability to hold properties: If you have a home that you hope to become an investment property in the future you may choose to store your surplus cash into an offset account rather than into the loan directly.
This can allow you to maximise the deductions when the home becomes an investment and your savings can go towards reducing the debt on your future home.
Con's • No forced additional repayments: Without being forced to make additional repayments you may spend the extra cash that otherwise would have been used towards reducing debt.
• Potential for higher principal and interest repayments once the interest only period ends: With lender policy tightening, it is becoming more difficult to extend interest only periods with the same lender and you may need to refinance to another lender if an extension is not possible with the existing lender.
Should you not be able to extend the interest only period or refinance the loan, your minimum monthly principal and interest commitment will be higher than if you had selected principal and interest repayments from the beginning.
• Higher interest rate: You are now paying a premium for the privilege of the extra flexibility and tax deductions that you receive from the interest only approach.
There is no one size fits all approach to finance strategy or property planning decisions and you should determine the approach that is appropriate based on your goals, risk tolerance and financial situation.
Risk management and money management are key components of a successful investment and finance strategy.