Low interest rates effectively make borrowing more affordable. With the Reserve Bank setting the cash rate at a record low, the flow-on effect to lending has been evident.
If a property investor is looking to maximise cash flow, one strategy is to pay only the interest portion of the property’s loan (and not repay the capital).
But this raises the question, what happens to the interest-only loans when rates fluctuate? The answer is business as usual, but first, what is an interest only loan and why do investors use them?
What is an interest only loan on an investment property?
Where an interest only loan used to purchase an investment property, the loan repayments only cover the interest, not the principal. In other words, the loan amount (principal) to purchase the property remains unpaid.
The interest only period usually has a set timeframe, for example the first five years of a 30-year loan.
Several banks and lending providers offer them.
Reasons investors use interest only loans
There are two key reasons why investors use this financing option.
1. To reduce expenses early and amplify cash flow
Principal repayments are a substantial non-deductible cost of owning an investment property. Some choose to delay principal payments to assist their cash flow earlier on in their investment property journey.
Lowering the costs early on by delaying principal repayments provide investors with more cash than they would’ve had. This allows them to reinvest cash flow to assist them in achieving a stronger financial position when the time comes to begin principal repayments.
2. To increase the loan’s tax-deductibility
It’s common for interest only loans to have a higher interest rate compared to interest and principal loans. This must be considered when deciding on a loan, but a result of this is the increased tax deductions.
Interest repayments on an investment property’s home loan are fully tax deductible to investors. This means the higher the interest repayment, the higher the tax deduction will be.
The deductions are also higher as the debt level isn’t being reduced. The higher deductions often help when an investor also has a home loan that isn’t tax deductible, as they can use the additional funds from not paying principal on their investment property to reduce the non-deductible debt. This is all while maintaining higher levels of deductible debt, which effectively increases deductions that reduce tax liabilities.
Tax deductions reduce property investor’s taxable income, so higher interest repayment claims can result in less tax to pay. According to the Australian Taxation Office, an average investor makes an interest repayment tax deduction claim of over $9,000 each financial year.
Pitfalls of interest only loans
1. Higher interest rate
As previously mentioned, an interest only loan usually has a higher interest rate.
While this does mean a higher interest repayment tax deduction, it’s important to remember that all deductions are taxed at the investor’s personal income tax rate. So $1 in deductions doesn’t necessarily mean $1 back in cash.
Furthermore, tax deductions can only be claimed at tax lodgement time (unless a Pay as You Go Withholding variation is in place). So the investor must ensure the constant cash flow impact can be managed throughout the financial year.
2. Increased future principal repayments.
Not making principal repayments in the early years of an interest-only loan has consequences in the form of elevated future repayments.
Let’s use an example of a $500,000 loan with a total term period of thirty years, and the first five being interest-only. The annual principal repayment will be approximately $16,660. Not making principal repayments in the first five years means the $83,330 that would’ve been paid in this period must be paid in the remaining twenty-five years. This would increase the total annual principal repayments to $20,000 per year.
3. Risk of stalled equity
The only two ways to build equity is through capital growth and paying down the principal of a home loan.
This means by opting for an interest-only loan the investor can only count on capital growth to build their equity. This element can be unpredictable as it largely depends on property market conditions and other macro-economic factors.
Despite the pros and cons, seeking the appropriate financial advice is paramount. Financial advisors and accountants are two key consultants to engage when deciding on the best financing option for your next investment property. They will be able to liaise with you as you discuss financing options with your lender or mortgage broker.
Reminder: Interest only loans don’t impact property’s depreciation
Despite the fact that the investor isn’t paying off the property’s principal, they can still claim depreciation on its structure and assets.
Depreciation is a process of natural wear and tear and is an exclusive tax deduction to owners of income-producing properties, including property investors. Just like interest repayments, depreciation reduces your taxable income so you pay less tax. The key difference is that depreciation is a non-cash deduction – so no money needs to be spent to claim it.
On average, depreciation can yield an average first full financial year deduction almost $9,000. To learn more about depreciation and how it can improve your investment property’s cash flow, contact BMT Tax Depreciation on 1300 728 726 or Request a Quote.