Important Guides to help make your Investment Home Loan work better for you; Interest Only versus Principle & Interest Loans (often referred to as I/O and P&I)
I cannot emphasise strongly enough how important it is to thoroughly check strategy involving Interest Only loans with your accountant. Common sense unfortunately doesn’t always agree with Taxation Office rulings.
Let’s start by going right back to basics. One of the main reasons we invest is to give us the future we wish for and, if they have been nice to us, we might leave some to our children – even in a blog I can have some humour.
Food and Shelter are two of our most basic physical needs. We should aim to retire with either a home that is debt free, or with enough capital to produce sufficient income to cover accommodation needs for the balance of life. There are products now called Reverse Mortgages but they are a last chance fall back – not a primary plan.
So what is the lesson? As a general rule it is sensible to have the home loan for your primary place of residence as Principle and Interest so that it is slowly retired over time. There are many good reasons to modify this rule BUT only if there is a strategy in place that still aims to have a debt free residence in retirement. Your mortgage broker, financial planner and accountant can work together with you on this.
This is where an Interest Only loan can become a part of an overall strategy.
You only have so much after tax income. Any interest expense on an income producing asset is tax deductible. Payment of principle must come from after tax income.
As a general rule you should aim to pay down principle on your owner occupied residence and reduce that debt before paying down principle on an investment loan, hence ..
- Your owner occupied home loan might be Principle and Interest.
- Your investment home loans might be Interest Only.
Ok – that's the general principle. Now for some finer points;
If there is a possibility that your current owner occupied residence might one day become a rental property, a Principle and Interest loan with minimum repayments and an offset account might be useful. You should discuss this with your accountant and mortgage broker.
I/O always has a term - let's say 5 years. After 5 years your property might be positively geared – therefore you might consider letting it roll to P&I then and let your tenants pay off Principle as well as Interest.This is really using other people’s money to create your wealth.
An interesting point, not widely known is that although an Interest Only loan has lower repayments and hence is "easier" to pay, they are "harder" to get. This is because the overall loan still has a term of 30 years. When a bank assesses servicability of a loan with a 5 yr I/O period, they assess it over the remaining 25 years. If you want a second 5 Yr I/O term , it is assessed over the remaining 20 years. Eventually the bank wants its money repaid!
Be very wary of any scheme that involves what is called “capitalising the interest” on Interest Only investment loans – effectively letting the loan increase. The taxation office has given specific warnings about such schemes – best not to be too smart and create a problem you don’t need.
Either way, there are a number of combinations of options suitable for creating your investment wealth.
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