Interest-only or principal-and-interest for a Victorian investment loan?

Interest-only investment lending was the bedrock financing structure for most investors during the unprecedented Australian property boom spanning from roughly 2003 through to 2017. It was an era where the mantra of ‘negative gearing while waiting for capital growth’ reigned supreme, and keeping loan repayments as low as possible amplified positive cash flow, or at least minimised the out-of-pocket holding costs. The regulatory landscape, however, underwent a seismic shift mid-2017 with the Australian Prudential Regulation Authority's (APRA) decisive intervention. Their mandate capped interest-only lending at 30% of new bank lending and, perhaps more significantly, demanded robust justification for any interest-only terms. This single intervention fundamentally reshaped the market, ushering in a new era of scrutiny and making what was once routine now a considered exception. As we navigate 2024, securing interest-only terms beyond five years at any of the four major banks has become a considerable challenge, almost an anomaly. Furthermore, the privilege of an interest-only structure now comes at a tangible cost, with rate premiums over principal and interest loans typically hovering between 25 and 45 basis points, making that decision a finely balanced one for investors in Melbourne and across Victoria.

Despite the tightened regulations and increased costs, the case for an interest-only investment loan is not entirely defunct; it retains its validity in specific, well-defined scenarios. The primary and often most compelling argument presents itself when an individual investor holds substantial tax-deductible debt against their investment property, while simultaneously carrying non-deductible debt elsewhere, most commonly a home loan on their primary residence. In such a situation, maintaining the investment loan on an interest-only basis liberates a greater portion of available cash flow. This freed capital can then be strategically directed towards extinguishing the non-deductible home loan much faster. By prioritising the reduction of non-deductible debt, the investor effectively optimises their overall after-tax financial position, as the interest paid on the home loan offers no tax relief. Consider, for example, a Melbourne professional with an investment property in Footscray yielding $600 a week and a $700,000 home loan in Northcote. If their investment loan in Footscray is $500,000, keeping it interest-only can free up several hundred dollars a month that can go straight onto that non-deductible Northcote mortgage, significantly accelerating its repayment.

A second, equally relevant use case for an interest-only structure arises when an investor anticipates significant lumpiness in their income. This could stem from various sources: substantial annual bonuses, the realisation of capital gains from other investments, shares vesting, or even commissions. For these individuals, the predictable lower outlay of an interest-only repayment offers invaluable flexibility. It allows them to maintain minimal ongoing commitments during periods of typical income, while providing the freedom to make substantial, voluntary principal reductions to their investment loan when these lump sum windfalls materialise. This approach can be particularly beneficial for self-employed individuals or those in commission-based roles, who might experience significant fluctuations in their monthly or quarterly earnings. A buyer in Brunswick, perhaps a freelance creative, might find this appealing, using a substantial quarterly project payment to knock down a chunk of their investment loan in Coburg, rather than being locked into higher principal and interest repayments all year. It offers a fluid approach to debt management, aligning with their irregular income patterns without forcing them into a financial straitjacket during leaner months. The key here is not merely the reduced payment, but the strategic optionality it provides to accelerate debt reduction at opportune moments.

However, it is equally important to acknowledge that in the contemporary lending landscape of 2024, the arguments against an interest-only structure have significantly strengthened, perhaps even outweighing the benefits for many. The previously mentioned 25 to 45 basis point rate premium is not merely a trivial surcharge; it materially compounds over a five-year interest-only term. This means that an investor could easily be paying thousands of dollars more in interest over that initial period compared to a principal and interest loan, with absolutely no reduction in the principal owed. For an investor with a $600,000 investment loan on a property in, say, Hampton, that 35 basis point difference could easily translate into an additional $2,100 per year in interest, money that is simply gone with no capital growth to show for it in their loan balance. This becomes a particularly potent factor when considering the long-term cost of borrowing.

Beyond the immediate cost, one of the most critical considerations is the transition to principal and interest repayments at the end of the initial interest-only term, typically after five years. This event often proves to be a significant borrowing capacity stress test for many investors. The sudden jump in monthly repayments can be substantial, particularly if the investment property is still negatively geared or if other financial commitments have increased. Lenders meticulously reassess borrowing capacity at this juncture, and a failure to meet the new, higher repayment threshold can lead to undesirable outcomes, including being forced to sell the property or refinance at potentially less favourable terms. Moreover, the ease with which one could obtain an interest-only loan initially is often not mirrored when attempting to refinance and retain an interest-only structure. Lenders are increasingly demanding robust evidence of a continued, compelling rationale for an interest-only loan, making it a much harder proposition to renegotiate than it was to originally secure. They want to see a clear path to principal reduction, not just a perpetual deferral.

For the investor in Victoria who finds themselves fortunate enough to have either completely extinguished their primary home loan or has it nearing full repayment, the principal and interest structure on their investment loan usually emerges as the clearer, more advantageous long-term strategy in 2024. In this scenario, the primary benefit of interest-only - freeing up cash flow to attack non-deductible debt - is largely removed. Embracing principal and interest means steadily chipping away at the investment loan's balance from day one, building equity more proactively and mitigating the risk of the "payment shock" when an interest-only period expires. It simplifies financial planning, reduces the overall interest paid over the life of the loan, and creates a more robust financial position for the investor. Consider an investor in Ringwood who has paid off their home loan. Taking a principal and interest loan on their investment property in Croydon means they are building wealth directly through debt reduction, rather than purely relying on speculative capital growth, which as we know, can fluctuate.

Conversely, for those investors grappling with substantial non-deductible debt elsewhere in their financial portfolio, the interest-only structure remains a defensible and potentially optimal strategy. However, this defence comes with a critical caveat: it absolutely must be paired with a meticulously crafted and adhered-to plan for the eventual transition to principal and interest repayments. This plan should encompass clear milestones for how the non-deductible debt will be reduced, how income will be potentially leveraged to make voluntary contributions to the investment loan, and a realistic assessment of future borrowing capacity. It is not enough to simply take the interest-only option; one must actively manage the underlying reason for doing so. A buyer engaging a buyers' advocate in Melbourne for a property in Pascoe Vale, looking to invest while still having a significant mortgage on their primary residence in Brunswick East, might still lean towards interest-only. But that decision must come with a rigorous, five-year financial roadmap detailing precisely how they'll use that freed up cash and what their financial capacity will look like when the P&I switch inevitable occurs. Without such a proactive strategy, the initial advantage of interest-only can quickly dissipate into future financial strain.