The attractions of interest-only loans
Despite the tighter regulations governing interest-only loans, potential borrowers can obtain substantial benefits from this source of funds.
With interest-only loans, the risks will fall only if the value of the collateral increases because of inflation-induced and other increases in the value of the asset. For the lender, a fall in value can substantially affect the loan backing and even result in the borrower moving into a negative equity situation.
This isn’t necessarily a matter for immediate concern provided the borrower has the capacity to continue to service the loan until asset values improve. Nevertheless, financial institutions and the regulators are legitimately concerned about future problems when the loan needs to be refinanced, especially if interest rates rise.
Clearly, the risks of borrowing are reduced if loans are repaid as quickly as possible. But in many situations, interest-only loans can play an essential role in wealth creation. For investors eligible for a tax deduction on the interest expense on all loans, paying off a loan will increase their tax liability, or for negative gearers will reduce their tax refund. Where the borrower also has an owner-occupied home mortgage, paying off the debt on the family home will be more beneficial because the interest isn’t deductible. Only when the family home is paid off will it be advantageous to start reducing an investment loan.
Even then, there may be more attractive ways to accumulate wealth, assisted by the continuing tax deduction for the interest-only investment loan. These possibilities include boosting tax-deductible super contributions, including for both partners of a couple.
This strategy has two benefits, the tax saving from contributing to super and the investment return in super exceeding the after-tax interest cost of the investment loan. The closer the investor is to retirement age, the more attractive boosting super balances becomes compared to paying off debt. At or after retirement, part or all the super account balances can be used to reduce or pay off the interest-only loan.
The point to remember is that interest-only loans are not as risky as often claimed provided the borrower is saving in a more effective way. Compared with interest and principle loans, interest-only borrowings reduce loan servicing costs. But using the additional cash flow for consumption purposes is a dangerous strategy that relies on capital appreciation to boost wealth.
As with other wealth-creation strategies, the key to a successful outcome is to evaluate all the available options. Interest-only loans can be a trap if their only attraction is the lower servicing cost.