Interest Only Vs Principal and Interest
The Problem & the Noise
If you have an interest only investment loan or an interest only portion to your mortgage you may have noticed some fairly dramatic changes to your repayments of late.
If you have not checked your current rate of interest recently and the following paragraphs inspire you to do nothing else: Please Review your interest rates and ask your Advisor: “Am I paying too much to my bank. “
Many lenders have raised their rates on interest only loans in response to recent APRA regulations, in most cases by 0.55% or more.
According to the regulator, this increased scrutiny has been in response to “an environment of heightened risks, reflected in an environment of high housing prices, high and rising household indebtedness, subdued household income growth, historically low interest rates, and strong competitive pressures”.
For the purposes of this article we won’t be challenging the validity of this macro perspective, it is however very, very macro. It is a view of the summed average of all residential lending in Australia and much like architypes of the average person and the average family – you may find it hard to identify with.
So with this new paradigm in mind – Which is better for you and your unique financial situation, Interest only or Principal and interest borrowing?
The Tried and True Approach.
Previously the conventional thinking used to make this decision for medium to high income earners was simple:
Investment Loan = Interest Only,
Home Loan = Principal and interest.
This strategy relied on the negative gearing and enhanced cash flow benefits of an interest only structure outweighing the long term interest saving usually derived from principal and interest repayments. For many medium to high income earning borrowers, opting for interest only was considered a no brainer. However the increase to interest only rates combined with lower rental yields for investment properties has eroded and in many cases eliminated the value in traditional negative gearing structures.
The result here is that many borrowers find themselves in mortgage structures that were considered savvy just a few months ago but are now ineffective and outdated. Both the interest cost and the opportunity cost of these older structures can be huge, so before we can answer the question: PRINCIPAL & INTEREST or INTEREST ONLY? We need some new thinking tools.
The perspective
I want you to imagine a seesaw, it is a rather peculiar seesaw because it has the uncanny ability to determine whether you are better served by an interest only loan or a principal and interest loan.So how does this seesaw work? It’s very simple: Assuming you want to keep your feet on the ground you will want to sit on the heaviest side of the seesaw.On one side of the seesaw we have interest only repayments and we can load this side with all of the interest only benefits like tax deductibility and lower repayments in the short term.
On the other side of the seesaw we have Principal & Interest repayments and we can weigh this side down with significant interest savings in the long term and potentially greater stability garnered from holding more equity in your property. With the changes to APRA regulations, the principal and interest side of this seesaw now has some additional weight with the added benefit of having a significantly lower interest rate with most lenders.
When we broaden our view of your unique financial situation further we can include other potential benefits to one side or the other, benefits like:
- Investment income
- The opportunity cost of not investing
- Your appetite for risk
- The emotional weight of a higher risk strategy
- Your short, medium and long term financial goals
- The impact on your lifestyle
- Cash flow for your business
- The flexibility to adjust your structure easily should circumstances change
- The impact on future family decisions.
The number and nature of benefits that you can use to weigh your seesaw down will be unique to you, your family and your business. The old conventions no longer hold true and approaching your mortgage and other lending requirements without understanding all of the weights on your seesaw can easily leave you with your head in the clouds all the while believing that your feet are firmly planted on the ground.
The Solution
It requires the care and diligence of a panel of trusted advisors who value their relationship with you above and beyond the singular transaction of restructuring your loans or acquiring credit on your behalf. It requires expert advisors who can identify all of your unique seesaw weights and can provide holistic, discerning advice to steer you on your chosen path.The good news is that we can help you navigate this path. Contact our in-house loan specialist David Learn for a free consultation and “mortgage health” check.
