Category Archives: Home Buyer Central

The pros and cons of interest only loans

The pros and cons of interest only loans_001

Investors often choose interest-only loans to build their property portfolio. I’ve been asked about it often and here are my thoughts.

What is an interest-only loan?

Normally, when you take up a home loan, you need to pay a portion of the principal and interest (P&I) every month. With interest-only loans, you only pay the interest component of the loan and not the principal component. These loans are usually 5 to 10 years interest-only, after which the bank will want you to pay off the principal.

During the term of the interest-only loan, your repayments will be lower and hence make it affordable for the first few years. Some examples of when interest-only loans are chosen over P&I loans.

a) You are currently on one income and your wife is on maternity leave. You know that once she goes back to work, you will have more cash flow. So, to make it easy on your cash flow, you may choose interest-only option for 3 – 5 years.

b) Another example is when investors are building their property portfolio and want to keep their borrowing capacity to the higher limit or make minimum repayments only, they may choose interest-only loans.

c) First home buyer who wants to get into the property market, can choose interest-only loans to make it easy with their repayments for a while.

Advantages of interest-only loans

  • Tax deductions: Investors are often advised to take up interest-only loans because the interest component is tax deductible and hence they just pay what they can claim. This can help them in two ways. One, if they want to increase their borrowing capacity a little bit to be able to borrow more, this can help. The second is that they can use the extra cash flow to reduce their non-taxable debts.
  • Lower repayments: For the term of the interest only loan (1 – 5 years normally), you will be making lower repayments than a P&I loan. This helps when you are under a tight budget, but know that your financial position will change in the near future.
  • First Home Buyers: As mentioned above, interest-only repayments help first home buyers to get their foot in the door sooner and hence get into the property market without being overwhelmed.

Disadvantages of interest-only loans

  • Not gaining any equity: When you repay only the interest portion, you don’t reduce the principal component and hence you will not gain any equity in the property until you are making interest-only repayments.

If you want to sell your property post interest-only term (be it 5 years or 10 years), your loan amount will not have gone down and you will be liable for the full loan amount back.

So basically, unless your property value has gone up during the interest-only term, you will not have any equity.

  • Higher repayments at the end of the interest-only term: Once the interest-only term finishes, you will be asked to make higher repayments.

Example: Let’s assume you took a 10 year interest-only repayment option. At the end of the 10 years, you will be asked to make principal and interest repayments over 20 years, which can be a large increase in your repayments. This can often catch you off-guard because you were not expecting it.

  • Affordability: You may be better off in the initial interest-only term, but if you don’t plan for the future, you may find yourself struggling to pay off the principal and interest afterwards. Also, the interest that you pay post IO period can be quite high.

Always consider the pros and cons of any loan feature and make a decision that will suit your lifestyle. If unsure, feel free to call us to help you make that decision.

Dangers of cross-collaterisation

Most investors use equity in their current owner occupied and/or investment property to access cash and buy more properties. Tapping into this equity can help investors build wealth more quickly. Most investors do not understand how the equity can be accessed and often end up accessing equity through the wrong structure. Lenders and brokers choose a structure that is favourable to them rather than clients (YOU).

What is cross-collaterisation?

Cross-collaterisation is when once property is used as collateral to secure another loan. So, the lender has two securities against one big loan. This provides extra security for the lender, but is not favourable for the borrower. If the borrower is unable to make repayments on the cross-collaterised loans, the lender can force sale of all collateral in the mix.

Why you should avoid cross-collaterisation?

Here are four reasons why you should avoid cross collaterisation.

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1. Lenders have control over all your properties

Banks always put their best interests at heart and try to reduce their risk in every deal as much as possible. What better way to transfer the greater risk to the borrower than to cross-collaterise?

Here is an example:

Property 1 (worth $400,000) and property 2 (worth $400,000) are crossed.  Two years later, property 2 has gone up in value by $50,000 and property 1 has gone down in value by $50,000. Your portfolio is still worth $800,000 only.

If you wanted to access the equity in property 2, your lender may restrict and not let you access equity because the two properties are cross-collaterised.

A worse case scenario can be when you want to sell property 2, your lender may not let you do that because the end LVR is not favourable to the lender. However, if your situation makes it necessary to sell property 2, then your lender may need you pay down the loan on property 1 before they will release title.

Cross-collaterisation can greatly restrict your freedom. It leaves your hand tied and puts the power in your lender’s hands and disrupts your investor journey.

2. Refinancing can be difficult

One of the benefits in the current market is that you can shop around to find the best deal and can move from one lender to another with minimal discharge costs. You should review your loan at least once a year and see what else is available.

But if your loans are crossed, you may find it hard to negotiate with your current lender – be it for better rates or to move to another bank, because they exactly know what challenges you will face.

When cross-collaterised, the process can be more hard and tedious. Not only will you face higher exit and/or establishment costs, you will have to revalue your entire portfolio.

3. Ongoing access to equity can be hard

One of the main reasons to refinance is access equity to buy your next property. If you are a seasoned investor, you are not going to stop with one investment property. As your property portfolio grows, you may want to access more equity.

If your properties are crossed, then depending on the mix of properties that have been crossed and their value, you may not be able to access equity. If the bank sees no change in the total value of your property portfolio (as explained in the above example), they will not let you access any equity. This means that you are missing out on buying another property even though you have equity.

Should they all be separate loans, it doesn’t matter to the bank which property has gone up or down in value as they are all stand alone loans as they would have no knowledge about the performance of other properties.

4. You can put your owner occupied house at risk

Many a time, it is your owner occupied property that has considerable equity. If you cross this property with an investment property and should there come a time when you default on your investment loan, your owner occupied property or your principal place of residence is also at risk and you can end losing this house.

I never understand why someone would put their own home at risk because they are saving some $$$ on mortgage insurance or because someone they trust suggests them to cross it. Honestly, the only reason I think is because your bank or broker is getting paid more by crossing. I don’t see any benefits for the borrower – only that you can end up paying mortgage insurance on the whole loan amount (do you know it can cost you tens of thousands of dollars mortgage insurance on a cross-collaterised loan?)

The proper way to access equity

You might have heard rumors that it is necessary to cross-collaterise to secure a good interest rate. That is so not true.

The best way to make sure if your loans are crossed or not is by looking at the part of your loan contract which has the security and see if it mentions one address or two addresses as security. Look for this before you sign the contract, because once you cross the properties it can a nightmare and take ages to uncross it.

As you grow your property portfolio, make sure every loan is secured by one property only.

Here is another example.

Let’s assume you buy a property worth $400,000. You spend $30,000 on minor renovations. The market moves in your favour and within a year the property is now worth $475,000. If you originally borrowed $380,000, you still have the same amount of loan. If your lender will let you top up your loan to 90% of the increased property price, then you will be able to access $47,500 giving you not only the $30,000 you spent but an extra $17,500 that you can put in your offset account or use for further renovations or property purchases.

So, avoid cross-collaterisation and keep all your loans separate and enjoy greater freedom!