As the name suggests, an interest-only loan is one in which the periodic payments made by the borrower to the lender include only the interest that has accrued on the loan. To give a simple example: if a borrower borrows $100,000 at 6% per year, and is obliged to make one repayment a year (this is an illustrative example), then the amount paid to the lender will be $6,000.
Interest-only loans contrast to principal and interest loans, in which the periodic payments include an amount of repayment of the initial amount borrowed. With an interest-only loan, at the end of the loan period, the amount borrowed is the same as it was at the commencement of the loan period. The borrower has simply serviced the loan.
Interest-only loans are often used when the amount borrowed is used to purchase investment assets. By making these ‘investment loans’ interest-only, the borrower avoids having to use cash flow to make loan repayments on debt that is giving rise to tax-deductible interest. Accordingly, ignoring changes in interest rates, the amount of tax-deductible interest does not reduce over time.
1) Allows to pay off non-deductible debt first
By not repaying the principal amount of the investment debt, the borrower ‘frees-up’ cash flow to be used for some other purpose. This may include the repayment of other loans which were not taken out for investment purposes, such as a private home loan.
Because the interest on the private debt is not tax deductible, private (non-deductible) debt is effectively more expensive than investment debt. So, by preferring to repay the expensive debt, the borrower reduces the effective amount of interest paid overall.
2) Allows Capital Growth to do the work for you
Interest-only loans are also used where borrowers expect the capital value of the purchased asset to increase over time. To give a very simple example: suppose a borrower borrows $100,000 as an interest-only loan and uses it to buy units in a managed fund. The loan term is five years. After five years, the managed funds have increased in value to $130,000. The borrower sells $100,000 of the units in the managed fund, uses it to repay the debt and is left with an asset valued at $30,000.
Of course, there is a danger that the asset will not rise in value – but this is a risk of all investment borrowing and is not specific to interest-only loans. Indeed, where interest-only loans reduce the amount of after-tax interest being paid on all of the borrower’s loans, they can actually serve to reduce the overall risk to the borrower. The total cost of the debt is reduced, meaning that the amount by which assets need to increase in value so as to justify the decision to borrow to invest is lessened.
Interest-only loans are also sometimes used by borrowers who use the debt for private purposes, such as a home loan. This is usually done to maximise cash flow. For example, a family in the high cost years of raising children might change their home loan to interest-only so as to ‘free-up’ as much cash as possible for daily living expenses.
3) Allows you to use the extra cashflow to focus on Super and 'save' on tax
Another common purpose is where a borrower makes their loans interest only, and uses the money that would otherwise have been dedicated to repaying principal to finance extra superannuation contributions.
The plan is usually for the superannuation contributions to be withdrawn later in life and used to repay the loan. This can make sense because the superannuation contribution is only taxed at 15%, whereas the income may be taxed at a higher rate in the borrower’s personal hands. So, for every $1 of pre-tax earnings, the borrower can repay more debt if the $1 passes through their superannuation fund rather than their own hands. This strategy is discussed in greater detail here.
ASIC tells us that 2 out of every 3 investment loans is interest-only, while 25% of owner-occupied loans are interest-only. You can read more about interest-only loans on the ASIC website here.
HOW WE SUPPORT CLIENTS
At Profy Finance and Wealth, we have supported business and clients who are looking to finance commercial property assets, through:
- Arranging investment home loans and investment loans
- Ensuring investment debt is structured effectively
- Assisting in Accounting and Taxation needs with referrals to preferred accountants
- Arrangement and recommendation of SMSF lending
- Helping clients take an active approach to their finances
- Ensuring Debts and Mortgages are well managed and with good providers
At Profy Finance and Wealth, we get more holistic results for our clients. Learn more about how we could help...