Interest-only loans still have appeal

Regulatory changes by APRA and the introduction of the bank levy have added to the pressures on the banking system from an overheated property market and a slowing economy.

The major banks have responded by tightening borrowing requirements and raising the interest rates charged on investments, particularly interest-only loans.

APRA wants to reduce the growth of interest-only loans which, for sound reasons, are popular with investors and even owner-occupiers in special situations. The regulatory body has seized on the fact that principal and interest reduce the risk for both lenders and borrowers over time because of the regular loan repayments.

When property prices rise, lenders are protected by the higher values of the collateral for their loans. Their risks increase markedly however, especially for interest only loans, when property prices are high with the possibility of a market correction.

Borrowers still need to focus on the loans that best suit their situation. Interest-only loans can be the most attractive option for investors even if the interest rates are higher. Interest payments are tax deductible and the larger the loan, the larger the tax-deductible interest payment. Principal and interest loans are more attractive to owner-occupiers not able to claim a tax deduction for the interest cost. The faster an owner-occupied loan is paid off, the larger are the benefits of home ownership. Many investors also have a non-deductible loan on their principal place of residence. In this situation, an interest-only investment loan allows priority to be given to paying off their home loan.

This doesn't mean that an interest-only investment loan will guarantee the best possible outcome. The geared investment chosen must provide capital growth. If the investment doesn't appreciate, the after-tax interest cost of servicing the loan is wasted.

Some conservative investors choose to reduce their risks by paying off their owner-occupied loan before borrowing for investment. A principal and interest loan can then have attractions for investors as an easy way of building up capital for retirement. Over time, repaying the loan can result in the ownership of an asset providing a retirement income stream.

Depending on the size of the borrowing, interest-only investment loans are less likely to help accumulate assets providing a positive income stream. The need for regular income may even force the sale of a geared investment property triggering a capital gains tax liability in situations such as retirement or when the ability to service the investment loan changes.

Even if they may be more difficult and costly to obtain, interest-only loans retain their attractions for geared investors who still have home mortgages or other non-deductible debt.

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Daryl Dixon

Executive Chairman

Daryl Dixon is one of Australia’s foremost investment experts and a well known writer and consultant. He has provided trusted advice to thousands of personal clients over more than 25 years and is an acknowledged expert in the areas of tax, superannuation (including public sector superannuation), social security and investments.

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