What type of loan repayment would I like?

Borrowers typically have a choice between making principle & interest repayments or interest only repayments.

Interest only repayments

Under interest only repayments, you do not pay back any of the loan balance for the interest only period, you simply pay the applicable interest rate.  Usually you can set up an interest only period of up to 5 years for owner occupier debt, and in some cases 10 years for investment debt.

Interest only repayments has the advantage of improving your cash flow by minimising your repayments, maximising your tax position for investment debt and freeing up your capital for further use.

From 2017 onwards, interest only loans are commonly more expensive than principle & interest loans.  This has reduced the attractiveness of interest only loans for borrowers, as it now comes at a price!

However, during this period you will not actually be paying off any of your debt, so your repayments will go back up to pay this off once your interest only term ends.  Furthermore, your repayments rise faster, as the loan term will be smaller once the interest only period expires (20 or 25 years left to repay).  Overall, the cost of interest only loans is higher than principle and interest repayment loans.  Nowadays, lenders are charging higher interest rates for interest only loans.  They are also harder to obtain at higher LVRs.

For those with owner occupier debt, it commonly makes sense to have any investment debts at interest only repayments and your owner occupier debt being paid down (via principle repayments or via the offset account).  This is because the interest on your investment debt may be tax deductible, while the owner occupier debt is not.  Hence it makes sense to divert the extra cash flow to repaying your owner occupier debt first

Interest only with offset combination:

A common strategy for property owners who own their own home is to have an interest only repayment with an offset account used to ‘repay’ the loan.  This means the principle balance of the loan remains the same as it was originally (interest only), but the interest repayments fall every month as the offset account gets larger and larger.

This is beneficial as it gives you ‘control’ of the equity created over time.  It is sitting in the offset account and can be used by you at your discretion.  You don’t need to ask the bank to access this equity.

In addition, this is particularly valuable when the ‘own home’ that may become an investment in the future.  It is common to see borrowers pay down their owner occupier loan to a small/nominal amount, and then decides to upgrade their home while keeping the existing home as an investment.

While this is a good position to be in, the structure of your loans isn’t suitable.

In the above situation, the borrower will then have a very small investment debt left against their old residence, and a large owner occupier debt against their new home.  Given owner occupier debt is not tax deductible, this isn’t particularly useful.  In this scenario, borrowers are often ‘incentivised’ to sell their existing home given the poor tax/loan structure.

If the same borrower had instead used the offset account to pay down the loan, the principle balance of the old residence will remain.  The offset funds will be used to purchase the new residence.  This means a smaller owner occupier debt and a higher investment debt.  This is ideal, and can save thousands every year!

Principle & Interest Repayments

Principle and Interest repayments involve paying down the loan over time.  Each repayment is made up of an interest repayment and a principle repayment.  Usually the principle part of the loan will need to be repaid over thirty years, with the interest on the loan balance paid every month.

As the loan gets smaller every month, the principle repayment makes up a larger and larger portion of the repayment over time.   In the initial stages of a loan, the interest component will usually be larger than the principle component.  Over time however, as the loan is repaid, this will switch.

This has the obvious benefit of creating equity over time, as your repaying your loan and essentially ‘saving’ money.  This is great at incentivising financial discipline, as its hard to spend money that’s not there!  Its also cheaper than interest only loans.

This does however, shift some of the ‘control’ of your equity over to lenders