Opting for a principal and interest loan? It could be the most expensive mistake you’ll ever make…
An interest only loan is almost always a better way to finance property, even for an owner occupied dwelling, says property investment advisor and educator Richard Sheppard.
The traditional school of thought has always been to pay off your home as quickly as possible, so this concept may sound a little strange to some people. However, with as little as two to three per cent capital growth, the following approach far outweighs paying off your home loan. For a $500,000 home loan at an interest rate of six per cent per annum with a 30-year term, the repayments for a principal and interest loan are $2997 per month (or $692 per week) compared to $2500 per month (or $577 per week) for an interest only loan. Notably, the difference between the two amounts is $115 per week, which is the principal component of the repayment.
So your choice is, do you use this amount to pay off your loan, or do you use it for something else?
If you consider the fact that most new or near new $500,000 investment properties cost less than $50 per week to own after the usual tax benefits and rental income, then you could have used $50 to own an investment property, and the remaining 65 as additional loan repayments against the interest only home loan to build spare funds as redraw. As the rent of the investment property increases, you will have more funds to pay towards your loans or to buy another property.
If you just continue to pay off your home loan, without extra repayments, it will take 30 years to payoff. However, $ if you choose the interest only option and invest in a $500,000 property, let the investment property grow over time until it doubles in value (plus a bit more to cover costs), then sell it, and use the excess funds to pay off your home loan, you will be better off as long as there is at least two to three per cent capital growth.
For the past 40 years, Australian property has averaged about nine per cent capital growth per annum compounding. While it seems unlikely this will continue, with as little as five per cent growth per annum, it would take close to 15 years for a property to double in value. If you sold then and paid off your home loan with the proceeds, it would save you around 15 years of loan repayments or close to $540,000. In addition, you would have the equity and interest savings to invest further. You need less than $20,000 deposit and costs to start investing in property, so if you don’t have the cash or equity to invest now, you should only need to wait one to three years before you have sufficient equity in your home to make a start on this investment strategy.
While we always encourage making additional repayments where possible and good budget discipline, compared to a principal and interest loan with minimum repayments, it is still better to use an interest only loan with additional repayments because it builds up spare funds as redraw that, in turn, saves interest and builds a readily available cash reserve that can be used for any unforeseen expenses.
Richard Sheppard is the Managing Director of inSynergy Property and Finance Solutions. inSynergy provides professional property investment advice, property market research, specialised mortgage broking services and is an accredited investment property buyers’ agent. Visit www.insynergy.net.au or phone 1300 308 808.