Interest only loan question...

[MickStephens]

Hi everyone,

I like to write questions down as I think of them. A question that has come to mind is what the benefit of an interest only loan is if used for the life of the investment?

I usually try to answer my own questions, so please correct me if im wrong

If we borrowed $200,000 over 30 years to buy a IP to rent out, and repayments are $230 per week interest only, we are out laying $358,000 over the 30 years. ($230 x 12months x 30 years = $358,000)

Does this mean the idea is if the property rises in value to say $500,000 over 30 years, we are in front on paper by $142,000 in equity?

These calculations do not include maintenance or other usual costs involved in having an IP.

Do I have the right idea?

 

[HD_ACE]

Not really because your paying that interest if its io or p+i anyway.

The idea is to keep your cash liquid. So you put the cash in the offset instead which gives the same effect but can use the cash for a ppor or have quick access if needed.

Or you reinvest that cash into something that will give better returns ie another property to hold to be exposed to more growth.

Cheers

 

[Peter_Tersteeg]

Look at it from another perspective.

If you took an interest only loan 30 years ago (in 1984) to buy a property, how much would that loan have been and how much would it be costing you today?

If the property cost $30k back then, the loan might be $24k (80%) and interest would cost $1,200 a year (5%). Today that property might be earning almost $2,000 per month in rent and might be worth $1M+.

Even if my figures are way off, it still looks like a pretty nice deal.

 

[MickStephens]

Thanks guys.

So basically its using the banks money to invest into a property which will increase in value (As will rental prices) and in time not only start paying for itself but start to create a return.

Also, having an IO loan, any extra cash I would usually use on the principle of the loan can be used for other investments? ie IO = $230 p/w PI = $260 p/w The extra $30 can go towards saving for another IP etc

Sorry for my ignorance.

 

[Redom]

Hi everyone,

I like to write questions down as I think of them. A question that has come to mind is what the benefit of an interest only loan is if used for the life of the investment?

I usually try to answer my own questions, so please correct me if im wrong

If we borrowed $200,000 over 30 years to buy a IP to rent out, and repayments are $230 per week interest only, we are out laying $358,000 over the 30 years. ($230 x 12months x 30 years = $358,000)

Does this mean the idea is if the property rises in value to say $500,000 over 30 years, we are in front on paper by $142,000 in equity?

These calculations do not include maintenance or other usual costs involved in having an IP.

Do I have the right idea?

Hey Mick, never thought of it like that - interesting way to look at it.

The main thing youve skipped is the rental income - it will effectively offset your interest payment. Maybe even more than offset it (which others have alluded to).

If its a PPOR, that seems a fair 'absolute' figure calc.

Peter presents a good example of the last 30 years. His right, fantastic deal on paper. Noting that, i'm more sceptical about the price/rental rises over the next 30 years when compared to the last 30...but it'd still come out well ontop in absolute terms (inflation).

 

[Paul@PFI]

IO v's P&I is a personal choice.

There are debt averse people who hate all forms of debt. They borrow and rapidly repay. So P&I suits them. A fixed rate loan makes little sense as they want the ability to smash the loan. Then there are those who want to use the borrowed funds and don't want to repay debt. They see good v's bad debt. They should fix if they expect rates to rise as they are always exposed to rate changes. It hurts their cashflows.

I cant think of a better analogy than the old Italians - They hate banks. They hate debt.

IO can be very good at minimising outlays to access the growth in the property (only). A P&I loan adds equity from making capital reductions as well.

I guess it comes down to a question of surplus cashflow and liquidity.

 

[Peter_Tersteeg]

Peter presents a good example of the last 30 years. His right, fantastic deal on paper. Noting that, i'm more sceptical about the price/rental rises over the next 30 years when compared to the last 30...but it'd still come out well ontop in absolute terms (inflation).

The crux of it is that rent increases based on a mixture of inflation and demand. Once the loan is established it's not subject to inflation or demand so unless you go back and borrow more, the loan itself doesn't change.

Back in 1984 a $24k loan would have been a reasonable amount of money. Today it's almost nothing by comparison and there's plenty of people who can save that kind of cash in less than 12 months.

I'm also skeptical of price rises in the future, but I'm thinking in terms of 5-10 years. Over the next 30 years it wouldn't surprise me at all of we saw similar patterns to the last 30 years.

 

[Colin Rice]

Over the next 30 years it wouldn't surprise me at all of we saw similar patterns to the last 30 years.

me neither!

 

[Rolf Latham]

I cant think of a better analogy than the old Italians - They hate banks. They hate debt.

Fiat Currency..........

 

[MickStephens]

I cant think of a better analogy than the old Italians - They hate banks. They hate debt.

Oh I know this very well !!!

I work with/for an Italian Family who probably own the most real estate in our town. If anyone knows the Werribee area at all, you can probably guess their surname....

 

[Marty McDonald]

I like that analogy Pete.

Here is another - Get you name on the deeds then stay and pray.

This is from the richest guy I've met/ know. He has to be worth over $40 mil. He made his money in commercial property (small shopping centres) bought at low prices from mortgagee sales from Westpac when they were about to go under in the recession in 1991

 

[Scott No Mates]

Italicized version of Werribee: Guerrabi?

 

[Redom]

me neither!

I'm not sure how people get to this - or whether its just natural industry bias. Perhaps I just haven't seen it all yet and the economics of it has no real reflection in reality...I see the economics making sense of most things in the long run though..

Do people actually expect prices to quadruple again over the next 30 years? Besides basic affordability constraints...

1) Credit: Demand for houses is tied to availability/growth of credit. Over the last 30 years there's been significant deregulation - allowing for smaller deposits, etc. LVRs went to 100% and are at 95% today. There's no more room for this to go now.

2) Income growth: All tied to productivity growth over the long run...and I don't see how we increase on our last 30 years performance. Robots?

3) Cyclical growth: we haven't had a recession for 2 decades ... will that run extend to 5?

4) Population: Obvious long term effect of structural growth. With an ageing population not enough to quadruple prices!

Probably more of a post for the economics forum, but I couldn't help myself given that it came up!

 

[Gendry]

A quick newbie question re: IO vs P and I.

Does the interest really stay the same? If you pay back a chunk of the loan, don't you then pay interest on the chunk of the principal that's remaining? Ie less interest?

So if you borrowed 100k for 10 years after the first year wouldn't you pay a years interest on 90k remaining, rather than a years interest on 100k?

 

[D.T.]

A quick newbie question re: IO vs P and I.

Does the interest really stay the same? If you pay back a chunk of the loan, don't you then pay interest on the chunk of the principal that's remaining? Ie less interest?

So if you borrowed 100k for 10 years after the first year wouldn't you pay a years interest on 90k remaining, rather than a years interest on 100k?

If it's IO loan, then you still owe the same 100k whether its year 1, year 2 or year 30 for that matter. So repayments are still the same. Eg 5% interest rate x 100k total / 12 months = $416 per month. In 30 years time, obviously $416 will be peanuts.

 

[Gendry]

Cheers for the reply

Sorry I worded that post badly - I was referring to a P and I loan in my above example.

With one of those loans, You pay the same interest rate but on a decreasing principle, so less total interest every year, right? (100k, 90k, 80k... By the end your just paying 5% of 10k right?

Or is the interest repayment 5% of 100k every year, regardless? In that case the total interest paid after 10 years would be exactly the same as an interest only loan

Sorry for the total newbie question

 

[D.T.]

Yes you're right, the interest is charged on the decreased amount.

It isn't linear though. For example in the first year, each repayment comprises about 99% interest and 1% principle. In the 30th year that ratio swaps back the other way, and its a gradual curve in between. So its NOT 90k, 80k, 70k etc like you're saying.

You can google loan calculators online which demonstrate this.

 

[Terry_w]

Interest is generally calculated daily and charged monthly. So each time you make a deposit you will be charged less interest as the balance is decreasing.

 

[Gendry]

Cheers for clearing that up for me

 

[Chris B]

Cheers for the reply

Sorry I worded that post badly - I was referring to a P and I loan in my above example.

With one of those loans, You pay the same interest rate but on a decreasing principle, so less total interest every year, right? (100k, 90k, 80k... By the end your just paying 5% of 10k right?

Or is the interest repayment 5% of 100k every year, regardless? In that case the total interest paid after 10 years would be exactly the same as an interest only loan

Sorry for the total newbie question

Interest only isn't for everyone - but it does give you more options.

You can also have an interest only loan with an offset account attached. This means that you can put additional money into the offset account to reduce the interest charged each month. This gives you flexibility, as you can access the money sitting in your offset. If it is for an investment property and you use your offset money in future, it will mean you can still claim the interest on the full loan amount.