Three scenarious when an interest-only loan is OK
The Australian Securities & Investments Commission (ASIC) is cracking down on the interest-only loan.
After an eight-month investigation, the regulator found many lenders had been falling short of legal standards in assessing applications.
I'm all for responsible lending and in most cases I'd say you should pay principal and interest (P&I) on your loan.
But let's be real here. The combination of negative gearing and concessional capital gains tax means interest-only (IO) loans can make sound financial sense.
Here are three strong reasons to use an interest-only loan.
Flipping your home loan
When you flip your home into an investment you want to be able to claim the highest possible tax deduction. Paying P&I while it's a home loan will reduce later interest payments and hence the possible deduction.
Smartline mortgage adviser Scott McCray suggests you pay interest-only on your home loan and put extra repayments in an offset account.
This may mean a slightly higher rate, about 0.27% more.
"For tax effectiveness it is better to put the extra funds into a linked offset account instead of the loan," he says.
Let's say you have a $450,000 loan. If over time you put an extra $100,000 into your offset account, you still have a $450,000 loan but only pay interest on $350,000.
If you convert the property to an investment, you'd have a $450,000 loan and you could claim the interest as a tax deduction.
But if you'd put the $100,000 directly into the loan, it would be cut to $350,000 and, when you convert, you can claim only the interest on $350,000.
Cut non-deductible debt
On a $450,000, 30-year investment loan with an interest rate of 4.25%, the difference in monthly repayments between P&I and IO repayments is $519 a month (assuming a loading of 0.27% on the IO loan).
If you put this extra cash back into your $450,000 home loan you could save $120,000 in interest and shave nine years off your term. Plus, you'd maximise the tax benefits on your investment loan. Not a bad reason to be paying interest only!
Mortgage Choice CEO John Flavell says this strategy applies even if you don't have an investment loan but do have other personal debts at a higher rate.
"The interest rates charged on unsecured debt like car loans, personal loans and even credit cards are, generally speaking, considerably higher than the interest rate charged on a home loan," he says. "It makes sense for property owners to use the money they save by making interest-only mortgage repayments to pay down their various non-tax-deductible debts with higher interest rates first."
You plan to sell in a year or so
This could backfire if the property market slumps sharply but the idea here is that you minimise your mortgage repayments in the short term while your property value and your equity grow (or after your equity has grown).
Hotspotting reports numerous Sydney suburbs are up more than 20% in the past year, including Carnes Hill, Liverpool and Moorebank, so this strategy would have worked well.
Of course, hindsight is wonderful but not something you can rely on for future strategies.
There are drawbacks to interest-only loans, which is why ASIC is concerned. As Flavell says, "paying interest-only frees up your cash flow but if you end up using that extra cash to pay for day-to-day 'stuff' rather than for additional investment or to pay down other debt, it could well be wasted money".
Then there's also the risk that if rates go up and property prices down, an interest-only loan could leave you with negative equity. Plan IO loans wisely.