One of the questions I hear most often in relation to investment property is: "Should I borrow money to fund my investment property on a principal and interest or an interest-only basis?"
Principal and interest is the most common type of loan that most people use to buy a home they plan to live in. With this type of loan, the borrower pays back the principal over a set period (usually about 25 years). Part of the repayment goes towards reducing the principal, and the rest is interest.
In the first few years, only a very small portion of the repayment comes off the principal; most of it covers interest.
Principal and interest loans are usually offered at the prevailing variable interest rate. This means the amount we pay off the loan can rise or fall, depending on the current monetary policy.
Most people believe they should pay off their home loan as quickly as possible and, from a financial point of view, this is probably the best course of action.
When a principal and interest loan is used for property investment purposes, only the interest component of the loan is tax-deductible. As the loan decreases, so too will the amount of tax-deductible interest.
An interest-only loan is one on which repayments cover only the interest; nothing goes towards paying off the principal.
Most interest-only loans are also offered with fixed terms. At the end of the fixed term, the loan is either refinanced for a further fixed term, is repaid or reverts to a principal and interest loan.
As mentioned earlier, only the interest component of an investment property loan is tax-deductible, so with an interest-only loan, the entire monthly loan payment becomes tax deductible.
This has many financial benefits. The property requires less of your money to hold it, it is tax-effective and the fixed rate ensures that at least for the fixed term, there are no nasty surprises lurking with changes in interest rates.