Interest Only Loans

Despite the fact that an interest only loan will never be paid off, they are a popular option with investors who are able to maximize their tax deductibility using interest only facilities. The reason for this is that when a loan is taken out for investment purposes the interest charged on the loan becomes a tax-deductible item. An interest only facility is easier to manage in this sense because your accountant does not have to work out the proportion of interest charged per month as would happen with a principal and interest loan.

It is much easier for the accountant to simply total the interest charged on the loan statement and the job is done.

In fact, some financial advisers and accountants recommend that their clients use an interest only facility for investment purchases and redirect the money which would have been paid off the principal into personal debt. This reduces the interest charged on non-tax-deductible personal loans and maximises the interest charged on tax-deductible investment loans.

Let's look at an example that shows the difference between an Interest Only Loan and a Principal and Interest Loan.

Say an investor purchases and investment property for $500,000 and takes out a $400,000 or interest only investment loan. Assuming the interest rate is 7.2% per annum, the total interest charged on the loan over a full year would amount to $28,800. The entire amount of interest is fully tax-deductible.

If the same investor had taken a principal and interest loan at the same interest rate over a 30 year term the required monthly repayment would be $2715.15 or $32,581.83 per year. The interest paid on the first years repayments would be $28,672.67.

The key factor in this calculation is that the interest component of the loan decreases every year so that the tax deductibility factor becomes less effective.

By using the interest only loan repayments that would have been allocated to the principal can now be redirected to pay off personal debt.

Interest only loans versus Principal and Interest loans in a nutshell.

The interest is charged on interest only loan is fully tax-deductible.

The interest charged on a principal and interest loan is also tax-deductible but the amount of interest will be less each year.

The money which would have been used to pay off the principal on the investment loan can be redirected to pay off personal debt which is not tax-deductible.

The combination of these arrangements makes interest only facilities much more tax effective was at the same time supplementing the reduction of personal debt.

At the end of the day however, the investment loan balance will never decrease, so how does this make an interest only loan attractive?

The answer lies in the increasing value of the property.

Every investor wants to make a profit and although rental income can assist in loan repayments the income received from an investment property is not the major driving factor in acquiring a property portfolio. The real profit comes when the property is sold. Over the last 10 years property values have more than doubled in major capital cities and even more in some locations, so let's take a look at the difference between rental income and the increase in value of the property.

Say an investor purchases a house for investment purposes in 2004 $190,000. The average rent received over a ten-year period might average out at $275 per week which means that over a ten-year period the total rent received would be $143,000. Let's assume that the investor pays income tax of 40% leaving a tax-free component of $85,800 over 10 years.

As opposed to this, a property worth $190,000 in 2000 is now likely to be worth $450,000, an increase in value of $260,000. The current taxation rules mean that tax is payable on half of this gain ie $130,000, assuming the same taxation rate of 40%, the investor is left with an after-tax profit of $338,000.

This brief example explains the real motivation for acquiring an investment property. In summary therefore:

An interest only loan helps the investor to maximise tax deductibility in respect of the investment.

Rental income is helpful during the period of ownership because it helps offset loan repayments resulting in a more manageable cash flow situation.

The real benefit of owning an investment property is that the capital gain over an extended period of time becomes more and more attractive and is the real motivator for any investment strategy.

Of course, any investor needs to obtain professional advice from an accountant or financial adviser, or even a taxation lawyer. This is the only way to make sure that the investment strategy brings maximum returns.

A mortgage broker is not able to provide any advice in this respect, and neither is a bank. But, if you have a well-developed strategy worked out in conjunction with your investment professional, your broker or lender can point you in the right direction when it comes to the choice of home loan product.

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