Noel Whittaker's Blog I recently received an email pointing out that I often recommend interest-only loans for investment, and asking what the purpose of the strategy is. In the reader’s view, it seemed futile to take out a loan that you would never pay back.
The purpose of using an interest-only loan is to minimise your monthly interest commitment to give you a safety buffer, and also to maximise tax effectiveness. If you took a ten-year principal and interest (P&I) loan, you would find that the monthly payments quickly became mostly principal and less interest – this means every year you would have to find an increasing amount of pre-tax dollars to fund your repayments. Effectively, your monthly payments would increase every year as the tax deductibility drops – this could put you in a difficult situation.
Remember, the name of the game is to maximise your deductible debt and minimise your non-deductible debt. Interest only loans for investment allow you to maximise your spare available funds to pay back your housing loan faster. Once the housing loan is paid off, you can re-examine your interest only loan options – hopefully, your asset would have grown while the real value of your loan is reducing over time due to inflation.
A 30-year P&I loan does not have much higher monthly repayments when you take into account that these loans often have lower interest rates than interest-only loans. My mortgage broker tells me the going effective rate for an interest only investment loan is around 4.4% and for P&I investment loan around 4%.
At these rates, the repayments for a $500,000 interest-only loan would be $1,834 a month, and for a 30-year P&I loan $2,387 a month. After five years you would still owe $500,000 on the interest-only loan and $452,000 on the P&I loan.
Over 30 years that extra $553 a month, $199,000 over 30 years, is paying off $500,000. Sounds like a great deal to me.