Historically, I’ve often recommended that people repay interest only on investment loans. This approach offers two key advantages:
- Lower holding costs: Interest-only repayments reduce the ongoing cash flow required to hold an investment. This frees up money that can be directed toward repaying non-deductible debt or making other investments.
- Preserves tax-deductibility: By using an offset account to park spare cash, investors can reduce interest costs while keeping the original loan intact. This preserves the loan’s tax-deductibility and gives investors flexibility to use that cash in the future. Once a loan is repaid, it cannot be reinstated for tax purposes—its deductibility is gone forever.
However, interest-only loans now come with a drawback: higher interest rates. On average, the big 4 lenders charge a 0.26% p.a. premium for interest-only loans compared to principal and interest loans.
For some borrowers, switching to principal and interest repayments can be a smart way to save on interest costs while maintaining flexibility. If you reset the loan term every five years, the principal repayments remain relatively small. For example:
- On a $1 million loan, repaying principal and interest and resetting the loan term every five years results in only $20,000 of principal repaid over 20 years.
- After 20 years, your loan balance would still be approximately $980,000.
- This approach lowers your interest rate by 0.26% p.a., providing significant savings while keeping your cash flow manageable.
When principal and interest may not be suitable
There are two common scenarios where repaying principal and interest may not be ideal:
- Tight cash flow:
Principal and interest repayments are higher than interest-only repayments. For example, on a $1 million loan at 6.5% p.a., monthly repayments are:- Principal and interest: $6,320
- Interest-only: $5,420
The difference is $900 per month, which can strain your cash flow if your budget is tight.
- Substantial cash in offset accounts:
If you hold a lot of cash in offset accounts, principal repayments will be higher because the dollar value of principal and interest repayments are fixed and the interest portion is lower. This forces you to repay more of your loan, which may not align with your goals.
Tailor the strategy to your needs
Whether to choose principal and interest or interest-only repayments depends on your personal circumstances, financial plans, and cash flow priorities. Sometimes, a mix of repayment structures across your portfolio provides the best balance between flexibility and cost savings.
Tip: Always seek professional credit and tax advice to ensure your loan structure aligns with your overall financial strategy.
