Interest Only or Principal and interest?

Mar 29, 2017 (0) comment

Every mortgage has a number of decision points you must reach when working through the process. How much do you need? Which lender should you go with? How long should you take the mortgage out for? Each step of the decision-making process will have an impact on how much you pay and how long you will be paying it for.

On the face of it interest only seems the obvious way to go when taking out a loan. Deferring your principal until a later period will help reduce the amount of money tied up in repayments now, leaving you spare cashflow to continue with other investments – and many investors recommend this as the way to go.

But is it? An additional factor often not considered is how your lender will assess your ability to handle more borrowings based on the method you have chosen. A mortgage with an interest only period included in it will have reduced payments during the interest only period, but will require a higher commitment for the remaining principal and interest period once this has elapsed. Lenders will take this into account when determining approval for future borrowings.

Let’s illustrate

Jane takes out a $100,000 30-year mortgage with the initial 5 years being interest only. Good news for Jane in the short term as she won’t have to commit any of her cashflow to repaying the loan in the first five years and can simply focus on the interest payments during this period. The downside to this is that her $100,000 of principal repayments will be condensed into the remaining 25-year period of the loan, increasing her annual commitment during that time.

That may not seem an issue however due to her higher commitment over the remaining 25-year period Jane will be reducing her ability to borrow as lenders will assess her as being more heavily committed during this period.

By contrast Barry takes out a $100,000 30-year mortgage with no interest free period. Although Barry will have higher payments during the initial five years compared to Jane his principal repayments will be spread evenly across the full 30 years of the mortgage reducing his annual commitment overall. His ability to borrow and service a new mortgage each year will be greater as his annual commitment, at its highest point, is lower than Jane’s.

So, which situation suits you?

Reducing your short-term repayments can offer some immediate cashflow benefits but may ultimately affect your annual commitments and how you will be viewed if you return for further funding. When applying for funds it’s important to always think one step ahead. Ask yourself “If I structure this loan in this way what affect will it have if I need funding later?” Less than 10% of Australians own an investment property, but less than 30% of these investors choose to own more than one property. Many of those with just one property can afford to own more, but their mindset, and how they structure their funding, are amongst the biggest barriers to pursuing their financial freedom.

Have you structured your loans for future growth?

Is your debt structured to provide you with a strong chance to increase your portfolio? Talk to Ethan today about how you can structure your next loan or refinance your existing one to take advantage of your interest and principal repayments.

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