Interest only for investors: how long and at what cost

Cash flow: the repayment on a $600,000 loan at 6.2 per cent interest only is about $3,100 a month, against roughly $3,700 on principal and interest over 30 years. Tax: paying principal on an investment loan reduces deductible debt while the investor still has non-deductible home loan debt; the tax-efficient sequence is to pay down the home loan first and keep the investment loan interest only. Flexibility: surplus cash goes into an offset against the investment loan rather than into the principal, keeping it available.

The rate premium, commonly 0.2 to 0.5 percentage points, applies for the interest only period. The principal is deferred, so when the loan reverts to principal and interest it is repaid over a shorter remaining term and the repayment jumps, sometimes by 30 to 40 per cent. Total interest over the life of the loan is higher. The premium and the eventual step-up are the price of the cash flow and tax benefits.

Regulators require lenders to assess interest only loans on the principal and interest repayment that will apply after the interest only period, over the reduced remaining term, at the buffered rate. A five year interest only loan on a 30 year term is assessed on 25 year P&I repayments. That is a higher figure than the same loan on 30 year P&I, so interest only can reduce borrowing capacity even though it lowers actual repayments. Lenders also cap the proportion of interest only lending in their books, so appetite varies.

The loan reverts to principal and interest automatically. Before that, investors either apply to extend, which requires a new serviceability assessment, refinance to a new interest only period elsewhere, or accept the step-up. Extension is not guaranteed and lenders have tightened it, so plan the reversion date and the numbers at the start.