I often get asked by people new to the property market about how they should structure their investment property loan. The answer is never simple since there are many things to consider including fixed vs variable rates, interest-only vs interest+principal, your cash-flow situation, your investment horizon and the likelihood of future rate rises.
Fixed vs Variable Rates
Variable rates will generally cost you less in the long run. You can consider fixed rates when you know there are significant rate increases in the near future and where your cash flow may be severely hindered as a result. Although, if you are in this position in the first place then you may have over-extended yourself. For example, if you have a mortgage on your own home where the interest expense is not tax deductible then it might pay to have an interest-only repayment on your investment loans and then use the extra cash flow to pump it in to your home loan and pay it down faster.
One trap that new investors get in to with fixed rates is the possibility of having to be pay rather large "break costs" should you need to sell or refinance during the fixed rate period. Banks will look for you to pay out interest on the remaining term of the loan, especially when interest rates have dropped since you first took out the loan. This can amount to tens of thousands of dollars. Be careful with fixed rate loans when you plan to sell your property in the short term.
Interest-only vs Interest+Principal
Having an interest-only loan will give you more cash flow. If you can use this extra cash flow in a financially productive way then it is fine to stay with interest only loans especially given the interest expense is tax deductible.
However, the downside to interest-only loans is that you will pay more interest over the life of the loan and when you go for any new finance the lender will look at your ability to repay over the shortened term after the loan comes off the IO period. This will impact the amount you can borrow.
Setting up an Offset Account
Rather than pay off the principal, you can set up an offset account and have all of your spare cash, including the rent, be placed into this account. The offset account will offset your loan, meaning it will save you on interest. One extra advantage of this is that you can still access these funds for future investment purposes without having to go through a re-draw facility or apply for additional financing.
Getting the Best Rate
The interest expense is often the greatest expense of an investment property so one of the most important considerations is the interest rate itself. Push your banks hard and definitely shop around. If you are not getting at least 1.0% off the bank's standard variable rates then you are probably losing out. Saving .1% or .2% can mean a lot, especially on larger loans. Call your bank today and ask for a better deal.