Proof that interest-only loans are costing property investors more

Proof that interest-only loans are costing property investors more

Property investors are being urged to start paying down their home loans, thanks to the rising costs of interest-only loans.
 Peter Gearin
Peter Gearin

A new tool explodes the myth that property investors who choose an interest-only loan are better off than those with a conventional principal-and-interest loan.

Borrowers may think they are getting a better deal with an interest-only loan because they are paying less per month and their repayments are 100% tax deductible. But a new uno investment property home loan calculator, which shows the cost of financing an investment property through an interest-only loan compared with one in which the principal and interest are paid off simultaneously, proves that this is not the case.

A traditional loan is much cheaper than an interest-only loan because borrowers pay a lower interest rate and are able to reduce the overall amount they need to pay back straight away. And contrary to hat banks, mortgage brokers or financial advisers might tell them, investors who choose principal-and-interest loans rather than interest-only loans are typically better off from year one.

“If your aim is to get a better return on your investment, then anything that diminishes your return is a bad idea,” uno Home Loans founder and chief innovation officer, Vincent Turner says. “Given that interest-only loans cost more than principal and interest loans, unless you have some other factor – such as a need for cashflow – then choosing an interest-only loan is costing you money.”

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What the calculator measures

uno’s investment property home loan calculator measures a borrower’s loan amount and their property value, taxable income and rental income.

“With these values, we can estimate the total costs if your loan is interest-only versus principal-and-interest based on a rate you’re likely to get from our lenders,” Turner says. “It shows the cost to you by having interest-only versus principal-and-interest.”

Although the calculator only measures the difference in savings over a one-year and five-year period, it shows a clear advantage for those paying off the interest and the principal. Even those holding an interest-only loan who are looking to sell their investment property within three to five years suffer in the comparison. “They have even more to lose,” Turner says. “It’s a commonly held belief that ‘investment equals interest only’ in a loan structure. This no longer holds true.”

uno founder Vincent TurnerLet’s take, for example, Tom, who earns $118,000 per year. He is looking to borrow $544,000 to buy an investment property worth $680,000, from which he is hoping to get $300 a week in rent.

Using uno’s calculator, he is able to compare the merits of going for an interest-only loan, at a rate of 4.3 per cent, against a principal-and-interest loan at 3.9 per cent.

If he chooses interest-only:

  • Tom would gain an additional $916 tax benefit by going interest-only
  • He’d also enjoy a lower monthly mortgage repayment
  • However, over the first year he would pay an extra $2349 in interest.

If he chooses principal and interest:

  • Tom would slash $9748 from his investment property home loan balance in the first year alone.
  • This means the net benefit of Tom choosing a principal and interest loan over an interest-only loan is $3778 … and that’s just in year one.
  • Over five years, the benefit of Tom choosing a principal and interest loan is $25,373

Calculate what you could save

If you have an investment property, you can compare the costs of an interest-only loan with a principal and interest loan below.

This calculator assumes that the interest components of your home loan repayments are tax-deductible. There may be other expenses that can be tax deductible too – such as property management fees, or depreciation.

The interest-only myth

Banks, accountants and brokers have recommended investors use interest-only loans for years. Aside from being able to claim a tax benefit for the interest component of a loan (which is higher for interest-only loans), borrowers with an interest-only loan pay a lower total mortgage repayment each month than principal and interest borrowers. The theory is that they can put the money they would otherwise put towards their mortgage on servicing other debts or investments.

This potentially made sense when the price of interest-only and principal and interest loans were comparable.

But it has always been risky for investors to take out a loan that doesn’t require them to pay off the principal, even for a limited number of years. As investors with these loans pay back just the interest component, they might be encouraged to borrow more than they can truly afford. This reality often hits home only once the interest-only period ends.

Investors who take out interest-only loans also rely on strong rental growth and rising property values, rather than reducing their debt levels. This is a dangerous strategy when real estate markets go sideways, or even backwards.

Regulators act on interest-only loans

The Australian Securities and Investments Commission (ASIC) reports that about 60 to 70 per cent of investor loans are interest only; even about 25 to 30 per cent of owner-occupiers have interest-only loans (source: ASIC survey of 11 lenders, 2015). The chairman of the Australian Prudential Regulation Authority (APRA), Wayne Byres, says two in five residential mortgage loans in Australia are interest only (source: APRA).

Indeed, the recent growth in interest-only mortgages for Australian investors and owner-occupiers has been astonishing. Total interest-only borrowings rose from $88.7 billion in 2012 to $153.8 billion in 2015, with the average interest-only loan at $430,000 (source: APRA). Such uncapped growth led to ASIC and APRA moving in April to limit the number of interest-only loans to 30 per cent of total new residential mortgage lending. APRA also placed internal limits and more scrutiny on lending institutions that offer interest-only loans.

As a result of this regulatory intervention, lenders have increased the interest rates on their interest-only loans by as much as 0.7 percentage points compared with their principal-and-interest offers.

It’s this change that’s busted the interest-only myth: Now that interest-only loans more expensive, it likely no longer makes sense for property investors to choose them.

Stop ‘burning money’

Turner says rising rates and the restrictions on interest-only loans only reinforce the need for investors to choose principal-and-interest mortgages, which allow borrowers to pay off their debt faster and are better value overall. “We had a few customers come in who were looking at refinancing their interest-only loan because their lender had moved their rates up,” he says. “So we asked the question ‘Should you even be on interest only at all?’”

What does he say to those who are still on an interest-only investment loan? “Unless you have major cashflow issues, you’re literally burning money. Stop doing that, and start getting the advice and service you deserve as a property investor.

“If your current lender or broker hasn’t already reached out to tell you that you could be saving money by switching to a principal and interest loan, you have to ask whether they’re the right provider to help support your financial outcome moving forward.”

What to do next

Property investors have two options to get started in optimising their financial outcome.

It’s important to note that the information we give here is general in nature – no matter how helpful or relatable you find our articles. Even if it seems like we’re writing about you, it’s not personal or financial advice. That’s why you should always ask a professional before making any life-changing decisions.

 Peter Gearin
Peter Gearin

* Two year fixed rate, owner occupier, P&I package loan with a maximum LVR of 70% and a loan amount >=$150k. Lender rates and products may change. We cannot suggest you remain in or switch to any loan until we complete our assessment. Fees and charges apply. ^WARNING: This comparison rate is true only for the examples given and may not include all fees and charges. Different terms, fees or other loan amounts might result in a different comparison rate. The comparison rate is calculated on the basis of a loan of $150,000 over a term of 25 years. ± All loan applications are subject to uno assessment and lender approval. uno does not guarantee that it will be able to find a customer a better loan than the one they currently have or to save them money.