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How interest only loans can be an effective part of your borrowing strategy.
For many people interest is a necessary by-product of borrowing money. A necessity that they minimise by paying off the loan as quickly as possible.
However, in recent years, interest only loans have also come into their own as an effective way of controlling cash flow and building wealth through property investment.
Greg Bussell, Product Manager of Residential Investment Loans and Equity Lines with the ANZ Mortgage Group, says interest only loans are far more flexible and effective than most people realise. For example, ANZ offer interest only repayment options on variable and fixed rate loans.
Interest only loans are particularly popular among investors where the idea of gearing – borrowing money to increase the total amount of capital you have available to invest – has gained in popularity.
You can use interest only loans to:
- Purchase investment property
- Refinance an existing loan
- Cover bridging finance between the sale of one property and the purchase of another
- Minimise repayments during home renovations
“Because repayments are lower, interest only loans can be a very effective method of controlling cash flow during expensive renovations or between the sale of one property and the purchase of another. Property investors may also enjoy cash flow benefits,” he says.
With a typical home loan, your monthly repayments consist of principal and interest. With an interest only loan you just pay interest on the amount borrowed for the interest only period.
At the end of the interest only period you can allow your loan to convert to principal and interest repayments, repay the principal in full or refinance to another loan. Interest only loans are generally available for a fixed period of one to five years, but ANZ has recently introduced interest only terms of up to 10 years on most of its mortgage secured loans.
Many lenders now offer standard mortgages with a built-in interest only component. The loan may start off with a set interest only period and then convert to a standard home loan with all the required features. Interest only loans are also available as a stand alone product, such as a Line of Credit. However, at some point in time principal payments need to be made either by making the payments progressively or by paying out the loan from the sale of the property.
Advantages
- Lower repayments
- More cash for improvements to the property
- Set repayments (if the interest rate is fixed)
Disadvantages
- Increased risk
- Don’t build equity as quickly
- Repayments may increase at the end of the interest only term
Mr Bussell says interest only loans tend to appeal to more experienced borrowers.
“Generally, they are purchasing their second property and have been through the process at least once before and are comfortable with bank finance. They often have good budgeting skills because what borrowers are effectively doing with interest only loans is balancing cash flow with wealth creation or investment.”
Interest only loans can suit borrowers with short-term financial needs and property investors.
Short-term finance
If you buy a new home before selling your existing property, you may require bridging finance. Or, you might be living elsewhere while your home is renovated. By paying interest only, borrowers reduce the size of their repayments for a set period of time or until they sell their home.
Property investing
Interest only loans are popular with property investors or developers who plan to sell the property within a short period for profit. The lower repayments are useful if working to a tight budget. Interest only loans can also enhance the negative gearing tax benefits for eligible investors.
Long Term
Because interest only loans do not allow you to “buy” equity in the property, investors must rely on rising prices to realise a capital gain. Looked at another way, the loan repayments are simply the price you pay to own that asset while the market takes care of the capital growth.
This strategy is particularly effective when prices are rising (as in recent years) and when demand is high. It is more risky, however, when prices are rising slowly or when demand is falling. Rising interest rates, or economic conditions which lead to an oversupply of rental properties and make it harder to rent the property and also increase the risk.
It is recommended that you consider seeking professional advice before making investment decisions.
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