- Posted 27 Jan
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As a property investor, a popular strategy to manage cashflow and funds is to get interest only loans… and while these seem like a great idea at the time, there are a lot of risks associated with doing this, particularly if your situation changes and you’re not able to start making principal payments once the interest only period has passed.
It’s easy to understand why they are so popular though. They allow you to reduce your cashflow commitments in the short-term while allowing (hopefully) your property(s) to grow in value by the time you need to start paying off the principal amount.
What is an Interest Only Mortgage?
Just to be clear — an interest only mortgage is exactly what it sounds like… all that’s required of you, the borrower, is to repay the interest on the loan only, rather than both interest and principal, which is standard for most mortgage loans.
The interest only period will not be forever though…
Let’s look at an example. Say you’ve purchased a property worth $450,000, with a $400,000 interest only loan at 5%. Your monthly repayments are going to be small at just $416.67 (per week). Change this to a standard principal and interest loan and your weekly repayments are going to be $536.90.
It’s obvious why a property investor would opt for the interest only option, as the cost savings are major, and they will definitely help make any financial pressure your feeling that much easier… but only for the short term.
Understanding the Risks of an Interest Only Loan
There is a price to pay when opting for an interest only loan.
If you’re planning to hold onto the property for 7+ years (which is standard for a long-term property investor to see a sound return), then having only an interest only mortgage is going to cost you. You won’t be making any payments on the actual principal amount.
What this means is that if you had opted for a standard principal and interest mortgage, you would have paid off a significant amount on your overall loan.
Using the example above, if you’d opted for a standard mortgage; you could have paid off a good $66,000 (on the principal) in the first five years.
The trade-off with going the interest only route is that you won’t gain any equity in the property, even though you’re making monthly repayments. So if you’re looking to build your property portfolio and looking to use the equity in your first property to buy the next, you might find that there is none.
Understandably, most property investors base this strategy on the belief that within five years, the property value will have increased anyway. So using the example from above again, you might take your $450,000 property and hope that it will have at least increased in value to $500,000 over that five years, effectively gaining equity without having to pay a cent towards the principal.
If you’re interested in running some figures yourself, use a mortgage calculator to check for yourself.
Where the danger and biggest risk lies is in the ‘what if’ scenario… what if the property doesn’t increase in value, or doesn’t increase in value enough? Then what?
Then you’re left with a property that is now essentially worthless in terms of equity.
The only time this strategy may be of use is if you’re planning to flip the property within 12 months, by renovating and adding additional value to the property this way instead.
No matter what option you’re looking at, seeking the advice of an independent mortgage broker is a great way to ensure that you don’t make the costly mistake of opting for an interest only loan.
Chat to the team at Australian Credit and Finance today to discuss your best options and what your investment strategy is for the long-term.