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How do interest only loans work as part of a strategy?

Discussion in 'Property Finance' started by PurpleTurtle, 18th Jan, 2016.

  1. PurpleTurtle

    PurpleTurtle Member

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    Newcomer question number #17:

    How do interest only loans work?

    - I understand that you only pay interest. This means you have more disposable income to support more investment properties.
    - I think I read that having an I/O loan and putting extra in an offset account is effectively the same at a P/I loan (if disciplined) but with more flexibility if you need access to the funds.
    - I understand that in the long run, it doesn't matter if you don't pay down the capital if you build a large portfolio which increases in value, then you can sell it down to pay of the capital owing on remaining properties.

    But when I look at loan info on bank websites, they talk about interest only period of <5 years, then the repayments are higher than than a regular P/I loan as you catch up. How do people do this in the long run? Do they sell properties when the I/O period ends? Do they refinance with a new I/O loan? Is there something else I'm missing?
     
  2. Rolf Latham

    Rolf Latham Inciteful (sic) Staff Member Business Plus Member

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    Some lenders allow IO terms up to 15 years.

    Typically, id be concerned if one got a loan on IO, but couldnt actually afford the roll over to PI............. that would be poor risk management from the front end

    ta

    rolf
     
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  3. Jess Peletier

    Jess Peletier Mortgage Broker - Australia Wide Business Member

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    Ideally, you'd extend the IO term and some lenders will allow this. Otherwise, you'll have to either start paying P&I or refinance to another lender to start a new IO term.
     
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  4. Peter_Tersteeg

    Peter_Tersteeg Finance broker and strategist Business Member

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    Keep in mind that if you're an active property investor, there's a good chance that the loan won't last 5 years in it's current state. Many investors make changes to the original loan within 5 years and they extend the IO period as part of this process.
     
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  5. Redom

    Redom Mortgage Broker Business Member

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    In terms of 'strategy' interest only loans assist in growing and mapping out a larger portfolio size. This is important for active investors looking to stretch their portfolio out.

    However, recent APRA changes mean that while I/O loans will reduce borrowing power with individual lenders. So if your looking to borrow 700k, and only have servicing capacity for $650k, moving to P/I will likely generate you the extra borrowing power required to fund the transaction.

    From a portfolio perspective however, utilising multiple lenders is an important part of building a portfolio. Your overall portfolio borrowing power will be higher if your contractual repayments on your debts are lower, which is one of the major benefits of I/O lending. Hence, you can map out an overall larger borrowing power for a portfolio with I/O lending, even though individual transactions may indeed be lower.

    Rolling over I/O periods will become increasingly difficult going forward. Investors may have borrowed in previous lending market conditions, which have changed substantially increasing the risk of I/O loans rolling over to P/I with limited 'get out' options like refinancing (other than deleveraging).
     
  6. PurpleTurtle

    PurpleTurtle Member

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    So, say I have an I/O loan on IP #1 and after 3 years the property as increased in value to the point I want to borrow against it for deposit on IP #2.

    Does the act of getting that deposit force the refinancing of IP #1 and at that point I can try to get another I/O period?

    Of course, having said all this, my gut is scared of going I/O.
     
  7. Redom

    Redom Mortgage Broker Business Member

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    It doesn't force it, as you can either choose to refinance your existing loan and restart the 5 year term or keep as is. You still have the choice, but given your going through the process, its often a good time to do it.

    I/O may not be suitable as a blanket strategy for all - it partly depends on your risk appetite, discipline with money and medium term goals in property.

    As an example, if the aim to get IP2 and pay them down, P/I may make sense too. If the aim is to get IP2 and then 3,4,5,6, than I/O is generally a suitable option as it'll fit your financing plan to get to that level of accumulation.

    Cheers,
    Redom
     
  8. Peter_Tersteeg

    Peter_Tersteeg Finance broker and strategist Business Member

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    Releasing the equity in your first property will requrie a new loan applicaiton, which can can easily incorporate the renewal of the interest only period. It might be a refinance, it often doesn't have to be.

    For some lenders they'll lend you more in the future if your existing loans are I/O, for most lenders they'll give you less in the future. On balance I/O probably improves the overall picture.

    If you've got good savings habits, there's no reason you should be concerned about I/O. There's certainly circumstances where one is more suitable than the other, this is really a conversation you need to have directly with a broker.
     
  9. Jason Tyrrell

    Jason Tyrrell Well-Known Member

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    You shouldn't be worried about I/O. It is simply minimising obligations. If you save all or some of the money in an account that you don't pay in principal for your first property, you can create a buffer or funds towards the 2nd deposit. As well as the option of using equity in the first investment, should it realise the anticipated rate of capital growth.
     
  10. PurpleTurtle

    PurpleTurtle Member

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    Thanks for the feedback everyone - it's been very helpful :)
     
  11. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    One of the main reasons for IO is so that you can divert funds to the payment of the main residence. Even where the main residence has been paid off it can still be good to go IO as you can build up cash in an offset account and, as long as you are disiplined, you can build a buffer up while saving the same interest. This buffer can then be used as deposits and/or to help you retire earlier.
     
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  12. Dwalsh

    Dwalsh Well-Known Member

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    Ideally you would have I/O if you have a ppor, run an offset to the ppor and divert everything in and out of this offset. That will pay down non deductable debt. If you don't have a ppor then I/O still may suit you as you can run an offset to one ip and pay everything in and out of it. This will mean you have cash money sitting in your offset which is a good buffer to have, or you can use it for anything you like. If you're looking to upgrade your ppor this is the way to go as you get more cash to pay down non deductable debt. Paying principal
    and interest can be riskier I think. once you have paid money in form of principal and interest you may not be able to refinance it later if your circumstances change like you lose your job. But if you had that money in a offset account and you lose your job you simply pay your bills from your offset as normal until you find a new job. Also paying off an IP also reduces your deductability as well. All depends on what stage you're at in building your portfolio. But in the building stage your trying to keep costs to a minimum, savings as high as you can, and a buffer to ensure a Safety net.
     
  13. kierank

    kierank Well-Known Member

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    I am a big fan of I/O with an Offset. I would use one when buying a PPOR, especially if there is any chance in the future that you might move out of your PPOR and rent it out (convert it to a IP).

    You can withdraw the money saved in the PPOR's Offset as a deposit for the purchase of your next PPOR and all the interest on the original loan is now tax deductible.

    If you had a P&I loan on your first PPOR, you could withdraw the principal that you had paid in but the interest on this withdraw would not be tax deductible as the money is going towards your next PPOR. The interest on the balance of the original loan prior to the withdrawal would be tax deductible as the first PPOR is now an IP, but you have polluted this loan with deductible and non-deductible debt. Not recommended!!!

    I like the flexibility of I/O with an Offset.
     
  14. ashish1137

    ashish1137 Well-Known Member

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    Hi,

    I am a bit confused. Sorry for basic questions but lets say i took a 100k loan with principal + Interest installmant as 500 Dollars for 30 years.

    While if i take Interest only, the installment will be 480 per month with may be 120 going to my Offset every month.

    The question is that in first case, I am charged interest on a reducing principal which is cumulative over the entire loan tenure. So with every month's installment, there might be a reduction of 4 - 8 dollars (hypothetically speaking).

    While in second case, may be I am constantly putting 120 dollars for a year. So my interest remains to be the same.

    I might end up paying a some small amount of interest on the reducing pricipal which i have missed because for the entire year i am paying a constant pricipal in my offset. Unless I am very efficient and constantly increasing the amount in offset.

    Do I make sense? How is this scenario handled? Does it actually impacts?
     
  15. Travelbug

    Travelbug Well-Known Member

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    #ashish1137 a lot of people worry about that. You need to be disciplined. You don't ned to worry about how much to pay.

    Say your P&I payment is $500 a month. You put that amount into the offset each month. Get the interest only payment deducted from that, automatically leaving the rest in the offset. So you don't touch it. The bank will deduct the correct interest each month (and yes it will decrease each month).
    That way your interest payments will be the same as if you were paying P&I.
    Or as most people here would do, they'd use it to buy more property.
     
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  16. ashish1137

    ashish1137 Well-Known Member

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  17. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Your actually putting an extra $100 into the offset each month so you would be saving interest on the IO method here.
     
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  18. JZ93

    JZ93 Well-Known Member

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    So can you keep refinancing to the point that your interest only for the life of the loan?
    My brokers told me 5-10 years is the max.... Although ideally I'd like interest only with an offset to the point that it matches the loan amount. Is this possible??
     
  19. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    5 to 15 years is the max, but as long as you can keep servicing you should be able to keep refinancing or extending IO periods.
     
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