The Benefits of Interest-Only Loans

You may have heard people talk about interest-only loans when they talk about their investments. Whilst the definition of what interest-only loans are is simple to explain, the reason behind them is something that has many people scratching their heads. Interest-only loans are simply that, loans where you pay only the interest expense and do not pay any of the principal amount off the loan. Meaning your loan balance remains exactly the same for the term of the loan. Easy! Now why would you do that? Many people from an older or more traditional way of thinking approach loans as something that you want to pay back as soon as possible and having full ownership of your asset is paramount. Whilst this may be true of an asset like your personal home for instance, an investment is something completely different.

By having the borrowed funds that were used to buy the investment property set to interest-only repayments, the total expense incurred in operating that investment is reduced as you do not have to factor in principal repayments on your lending. This is good as it allows your property to become cash flow positive quicker, at which time some of that income can be used to fund the next investment.

But what about the loan balance you ask? Most investors take a longer-term view, especially when investing in property. It is expected that over time property will increase in value, allowing the owner to make a profit when the property is sold. By taking the funds that you would have otherwise used to pay off principal amount of your loan and use it to invest in another property for instance the return on your dollar is generally assumed to be more.

As a very basic example, a couple purchase a rental property for $300,000. To accomplish this they borrow $200,000 from the bank. The set the loan to interest-only repayments and as a result make a small profit on a monthly basis from the rental. They use this profit to buy another rental property for the same amount a year later, borrowing exactly the same amount. So now they have 2 properties worth $300,000 each and have $400,000 of loans. Over a period of 10 years (long term view remember) the house values may have doubled (house prices double approximately every 10 years), now they have 2 homes worth $1,200,000 and loans against these homes for $400,000 still. The couple are now in a far stronger position than they would have been had they bought one investment property and had been paying the loan off over that time. This does not take into account rent increases over that time, which would put the couple in an even stronger position.

Interest only loans are not for everyone and I would recommend talking to your accountant or financial advisor before you sign yourself up for one if you are unsure.