Over the past two years lenders have been incrementally increasing interest rates on investment loans and loans with interest only repayments (as opposed to principal and interest). As the chart below illustrates, the average interest rate margin between a principal and interest home loan and an interest only investment loan is now 1.04% p.a. As recent as January 2016, interest rates for these loans were virtually identical.
This begs the question, should you switch your investment loan to principal and interest repayments to save approximately 0.47% p.a. in interest costs (i.e. difference between 1.04% and 0.57% in the chart below)?
The conventional wisdom for interest only repayments
The conventional wisdom has always been to set up investment loan repayments as interest only. The rationale for this is it allows you to have better control and flexibility over your cash flow and capital. That is, it frees up more cash flow which you can direct towards the repayment of non-tax-deductible debt (i.e. home loan) or invest in other assets for example. But you could always make principal repayments at any time.
This approach had strong merit whilst interest rates for all loans and repayment types were virtually equal i.e. there was no penalty for repaying interest only compared to principal and interest. However, now this has changed, does it still make sense to have interest only repayments?
Our rule of thumb
I have financially modelled the long-term impact of setting up an investment loan with interest only repayments compared to principal and interest (for people that still have a home loan). Obviously, if you set up your investment loans as interest only, you have more cash flow to repay non-tax deductable debt, as despite the interest rate being higher, the repayment does not include a principal component (only interest).
Here is the rule of thumb that I have determined:
If your total investment debt represents 40% or less of your overall debt, set up your investment loans on interest only repayments. However, if your total investment debt represents 40% or more of your overall (total) debt, then set up your investment loan repayments as principal and interest – subject to the exceptions mentioned below.
The reason this rule of thumb works is because if your home loan is relatively small (compared to your overall debt) then any savings resulting from making extra repayments (i.e. if your investment loans were on interest only it gives you more cash flow to repay your home loan) will be less than saving 0.47% p.a. on all your investment loans.
It is very important to note that as interest rates rise, the dollar value difference between an interest only repayment (at a higher rate) and a principal and interest repayment (at a lower rate) reduces. The table below sets out the monthly repayments for a loan for $750,000.
|Interest rates||P&I||Interest only||Difference|
|Current rates (say 4.60% for P&I and 5.07% for IO)||$3,845 p/mth||$3,169 p/mth||$676 p/mth|
|Current rates + 1.5%||$4,545 p/mth||$4,106 p/mth||$439 p/mth|
Exceptions to the rule of thumb
There are two important exceptions to the above rule of thumb.
Firstly, you must consider how important it is for you to acquire more investments. Sometimes, it is worthwhile to set up investment loans on interest only repayments to allow you a greater capacity to service more debt and/or invest in more assets. This would typically apply to anyone that hasn’t yet acquired the amount of assets required to fund retirement yet – unless they had a substantial income. However, if you do not need to invest in anymore assets and are in a ‘consolidation’ phase, then switching to principal and interest repayments might be the way to go.
Secondly, if you lock yourself into principal and interest repayments now, you must consider the impact of future rate changes. At the moment, you save 0.47% p.a. by having an investment loan on principal and interest repayments compared to interest only. However, what if that savings differential evaporates but, due to tightening credit, the banks will now allow you to switch back to interest only repayments? There’s one thing that never changes, and that is changes in lending policies and interest rates. Just don’t be seduced into making a short-term decision.
If you do switch to principal and interest, it might be worthwhile resetting your loan term to 30 years to minimise the repayment amount. Otherwise, the repayment will be calculated on your remaining loan term.
Here is a decision tree to assist you with assessing your own position (click to enlarge):
Get professional credit advice
It is analysis and insights like these that could save you a lot of money!
Sure, finding the lender that will offer you the lowest rate is a good, short-term fix. However, finding a credit advisor (mortgage broker) that gives you advice and insights as well as comparing and negotiating interest rates will save (make) you substantially more in the long run. As always, play the long game.