Interest only or principal and interest? For an investment loan, it is one of the first choices a lender will ask you to make. Each suits a different stage of investing, and I have used both over the years.
The difference
| Interest only | Principal and interest | |
|---|---|---|
| Each repayment pays | The interest only | The interest and part of the loan |
| The loan over time | Stays the same | Falls with every repayment |
| Repayments | Lower, for a set period | Higher, from the start |
| After the set period | Usually reverts, and repayments rise | No change |
| The rate | Often higher | Often lower |
Why investors choose interest only
Lower repayments leave more cash each week, which can help someone carry a property or save towards the next one. While you are building, the property's value does most of the work: as it rises, the loan-to-value ratio falls, even with an interest-only loan. Interest on an investment loan is usually deductible. Interest on your home loan is not, which is why some investors put their spare cash against the home loan first.
Why investors choose principal and interest
Principal and interest builds equity through repayments as well as value, and the rate is often lower. Lenders see it as less risky. Every repayment brings you closer to owning the property outright, which matters more as retirement comes closer.
The stage you are at
I see this choice as a matter of stage. While you are building, the focus is holding the growing value of the property and keeping cash free. As retirement comes closer, the focus turns to income, and debt that served you while building becomes a weight. I have sat with people who reached retirement still on interest-only loans, having made minimal repayments to keep their cash for more property, with no plan for the debt. Seeing that coming ten years ahead is what makes the difference.
Who interest only does not suit
Interest only does not suit someone who would spend the cash it frees rather than put it to work, or who could not carry the higher repayments when the interest-only period ends. Lenders can decline to extend it, so the day it stops belongs in the plan from the start. The repayment type is not a detail. It is part of the plan, and it changes when the plan does.
Nicholas Lockhart
General information only. No advice is given. A broker can explain the loan options open to you.