Financial Game Changer #2: Using Principal & Interest Loans
Investors say don’t do it, but after reading this you may disagree. I was always told that as an investor I should be using Interest Only loans as they made my payments more affordable and I could leverage into the next property quicker. Reality has proven different though and there is hidden value in using a Principal & Interest Loan.
Paying down your loan using a Principal & Interest Repayment is a waste of time. Smart investors use Interest Only Loans.
For those of you who are not up to speed on the definition of these two loan strategies, a Principal & Interest loan is your traditional loan in which your loan repayments go toward paying down part of the principal (however small) as well as the interest that has occurred from borrowing.
An Interest Only loan, favoured by investors, is where the borrower only pays the interest portion of the loan while the principal amount remains unchanged for the life of the loan. This means you’re still left owing the original loan amount at the end of the loan, which would seem unthinkable in previous generations.
As investors, most of us choose Interest Only because:
- the growth in equity usually far outweighs the original loan amount once the loan is completed
- the tax deductions are greater as you can’t claim against Principal repayments
- the lower repayments reduce the pressure of holding the property
- the amount of money you save allows you to fund the deposit for another property
The first three points are without question, however it’s the last point that most people base their decision on. There’s no question that the repayments are less and the difference can go to fund the next property, but in reality what happens to this money?
Let’s have a look at an example:
Joe pays Principal & Interest (6.5% over 30yrs / 80% LVR)
Bob pays Interest Only (6.5% over 30yrs / 80% LVR)
Now here is the important bit.
The difference in these two repayments is $108.50 a week.
Now in reality, do you diligently put this portion of money away in a separate account called “Next Property Deposit”? Probably not. If you’re anything like me that little extra money just bought the family a take-out meal and a bottle of wine ie. improved my quality of life.
So for those of you who chose Interest Only and haven’t managed to put this money aside, here is the bitter pill.
Over the life of the loan Joe will pay $169,260 ($108.50 x 52 x 30) more than Bob who’s paying Interest Only. That means that after 30 years their debt position looks like this:
Joe – Debt: $0
Bob – Debt: $480,000
Joe has effectively paid off $480,000 worth of debt for $169,260.
So if you’re not being disciplined and putting that extra money aside, you’re doing yourself a great disservice as this money is worth nearly TRIPLE it’s value at the end of it’s life.
HELPFUL TIP: As an investor it can be much more beneficial to use any extra money to leverage into the next property rather than pay down the principal. A friend of mine, David Merison from Vault Plus Finance, advises setting up an additional account in which you pay the same amount as Principal and Interest repayments, however the lender only withdraws the Interest Only repayments, leaving you with the difference to fund the next purchase. Obviously this account should be kept separate and shouldn’t be attached to any discretionary spending, like wine.