There's often debate from investors on the best way to structure their mortgage payments in order to maximise return, but very seldom do they ever come out with a compelling answer.
Here, we are going to discuss how investors can pay less on their mortgage, and invest faster. Remember, this is only based on investment property, not your home-loan payments on your own house.
There are two different ways you can structure your mortgage payments:
1. Principal & interest
2. Interest only
Principal & interest is exactly what it sounds like, the owner pays the interest on the mortgage (based on your current interest rate), plus they pay down a portion of the principal at the same time.
This gradual payment is called amortisation and is essentially the process of gradually writing off the initial cost of an asset - i.e. the principal balance.
At the start of the 30-year loan term, most of your regular payment is to pay off the interest cost because your principal is high and the interest owing is also high.
Over time though, as your principal reduces, there is less interest to pay, but your payment amount stays the same because a larger portion of your payments goes toward the principal and less toward the interest cost.
Here is an example of an amortisation schedule where over the 30-year term, the costs stay at $3,000 per month, but the ratio of interest-to-principal payments changes.
The alternative method is just to pay interest only.
In this case, the investor solely pays off the interest portion of the loan and the principal balance remains the same over the life of that interest-only period.
Banks generally offer 5 years of interest only at the initial application and after that time elapses, your broker will be able to help you either reapply at your existing bank or refinance to another bank and get a further interest-only period.
People tend to be drawn to principal and interest loans because they think paying down debt increases the value, but this is actually untrue.
Paying down debt does not increase the value of a property. The profit you make is the difference between the buy price and the selling price, not mortgage repayments.
Consider this example:
You purchase an investment property today for $600k
You got 100% lending (i.e. your loan balance is $600k)
10-years later you've paid down the principle of the mortgage to $300k
The property doubles in value and you sell it for $1.2m
What profit did you make?
Although it seems like you made $900k; because $1.2m- $300k = $900k, this is incorrect.
You have in fact made $600k. Here's how:
Profit = Sell Price - Buy Price
Profit = $1.2m - $600k
Profit = $600k
Paying down a property does not increase its value so, every dollar that you put into paying down the mortgage is a dollar you’ll get back at the end.
The principal repayments are just a return on your money. The profit is generated from the capital gains, not the repayments.
One of the key benefits investors get from interest-only loans is that their cost to own the property is substantially lower than if they were on a principal & interest loan.
To demonstrate this, consider this example:
If you had a $500,000 mortgage at a 4% interest rate, this would require the following:
Interest-only payments of $1,667 per month
Principal and interest payments of $2,387 per month
That's a difference of $720 per month or $8,640 per year.
As a result of lower costs, you have more cash freed up and you can put this back into paying down the principal on your own home loan rather than the investment property.
With more equity in your own home, you are able to pull out a deposit from your equity sooner and start investing again.
Clearly, interest-only loans are of great benefit to investors – but in some cases, they would not be appropriate. Take these two scenarios:
On one hand, you have a high-income 30yo who is building their property portfolio by leveraging everything at 100% with interest-only loans because they have a 35-year time horizon before they retire where they will rely on the capital gains over that period to justify their investments. In this case, the more spare cash they have, the better because this frees up serviceability to reinvest in another property. At retirement, this investor can sell off as many properties as required to freehold the balance and live off the cash flow.
On the other hand, a 60yo who is looking to retire in 5yrs wouldn’t spread their surplus income across a bunch of properties, they would likely buy one and put cash into it to aggressively attack the mortgage with principal & interest payments so at retirement they can live off the net asset’s income stream. There is less time to rely on capital gains in this case so paying down the principal aggressively is the preferred option.
At the end of the day, instructing your mortgage payments needs to be done on a case-by-case basis but generally speaking, interest-only loans are hugely beneficial for investors and allow them to pay less, and invest faster.
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