How To Choose The Best Loan For Your InvestmentSeptember 30 2021
'Choosing the right loan for your investment is crucial when purchasing a property. This article can help you choose the right loan for your investment.' - Jesse Lee, Digital Product Manager
Most people don’t know it, but the success of an investment property does not only depend on choosing the right property but also on the right investment property loan.
It’s understandable that most investors focus on the property first when thinking about property investing, but getting the financing is the crucial first step before you can buy an investment property.
But how do you choose the right loan? Read more to find out.
Generally, loans for investment properties are not very different from owner-occupier loans. But to have a successful property portfolio, you need to have a solid investment strategy in place to determine the kind of loan that best fits your needs.
The type of loan you choose can also significantly affect your cash flow. Therefore, investors must think in what manner they would be repaying the loan before choosing a financial product that suits their investment strategy.
With that said, let’s see what loan options are available to property investors and how you can choose the right one that fits your strategy.
Types of investment property loans
Here are the different types of loans investors can choose from:
- Principal and interest (PI) loans
This is the most common type of loan used by owner-occupiers who aim to pay off their mortgage in the shortest amount of time possible. In this type of loan, the repayment is made up of the interest rate and a portion of the principal so that you pay a part of the original purchase price along with the interest right from the start.
As the principal amount reduces, so does the interest payable on it. Consequently, a larger part of the repayment is applied towards the principle in later years, gradually setting borrowers free from debt.
- Interest-only loans
Interest-only loans are the most preferred type of financing used by property investors in Australia. This is because interest-only loans can be used by investors to maximise their tax-deductible expenses. Interest-only loans can be fixed or variable.
With an interest-only loan, your repayments will only cover the interest component of your loan for a set period of time and do not reduce the principal amount you owe. Because you’re not paying off any of the debt on the property, you can keep your repayments to a minimum and it can also be claimed as a tax deduction.
Generally, interest-only loans are for a maximum five-year term (depending on your loan provider). At the end of the agreed term, you revert to a principal and interest loan. But in some cases, a further interest-only loan can be negotiated with your lender at the end of the term.
This type of loan is considered as the best cash flow when used hand in hand with good capital growth. Assuming that the property’s value goes up enough over time, an investor can eventually sell it and then use the money to pay off the principal while still making a profit.
However, there is always a risk with interest-only loans that the investment property’s value doesn’t sufficiently rise, which can saddle you with a large debt.
- Equity loans
Do you already own a property? If the answer is yes, then good news! You can use the equity in one property that you own to secure a home loan for the next one. The equity in your property can be used to fund the deposit on your investment property loan.
Most lenders allow you to borrow up to 80 per cent of the equity in your home. You can borrow a lump sum against the equity in your home or choose to open a line of credit that acts like a credit card with a large credit limit while your property serves as collateral for your mortgage. The best part of this setup is that you will only pay the interest on the amount you draw down from your line of credit.
Tips to finding the right investment property loan
Now that we’ve discussed the types of loans you can access, here are practical tips on how to choose the right one.
1. Do your research.
If you’re new to the real estate scene, the terminology surrounding investing and home loans can be confusing and complicated.
It’s a good idea to step on the brakes before you even think of applying for a loan and learn all the concepts related to property investment such as negative gearing, property cycles, tax concessions for property investors, and depreciation to help you make a more informed decision.
To help you get started, you can bookmark Smart Property Investment’s Glossary of terms - Research page for all the terms related to property investing. You can also tune in to our podcasts covering a wide array of topics that can help you become a smarter investor.
2. Make sure to have a solid investment strategy.
Once you’ve done your due diligence, you now need a plan. Your investment strategy will be a key factor in determining the type of investment loan that you will choose.
For investors who are in it for the long haul, they choose to follow the “buy and hold” strategy. For example, they may choose to buy a property and pay it off fully over time while collecting rent.
Meanwhile, other investors who are confident that their property will appreciate rapidly can choose a different type of loan.
If you already have a property that you fully own (or you have paid off most of it), then you could use its equity to fund the purchase of your investment property. This will boost your borrowing power and you will not need to worry about saving up for a big down payment.
Or you could take out a line of credit loan rather than a traditional investment home loan.
An investment strategy is just one key element of your financial plan. When considering making an investment of any kind, it is important to make sure it’s in line with the bigger financial picture you’re mapping out.
3. Strategise your repayments
To properly manage your finances, you have to make sure that your payments are organised in a way that will best fit your needs.
Firstly, your repayment terms will depend heavily on your investment strategy.
For example, if you’re buying a property and you are confident its value will increase quickly, you can make small interest-only repayments. This lowers your costs before your property is sold (ideally for a large profit).
Meanwhile, interest-only loans cost more in the long term, but it will not be a problem if your property does not see strong capital growth.
For risk aversive long-term investors, planning to pay off their investments in full while collecting rent, a principal and interest loan will cost less in the long run. With this strategy, you can also build equity faster.
4. Selecting the best interest rate
The interest rate of your investment loan is obviously an important factor. Typically, the lower the rate, the lower your repayments will be. Even a difference of 10 or 20 basis points can add up to tens of thousands of dollars in repayments over the term of a loan.
You’ll also need to decide whether you want a fixed or variable interest rate. Variable rates can rise without warning, but they can also fall.
Fixed-rate loans offer a period of certainty where you know exactly how much your repayments will be. While you’re shielded from rate rises during the fixed period, the downside is that you won’t benefit from cash rate cuts.
You can also hedge your bets by splitting your loan, making a certain percentage variable, and fixing the remainder.
While interest rates are important, they should not be the deciding factor when choosing a loan. Additionally, make sure you read the fine print for any hidden charges which can hurt your pockets in the long run.
5. Get a loan with the features you need
Last, but not least, make sure that you check a loan’s features. Knowing which types of features an investor loan offers can help you identify what will work best for you and make the most of your investment.
A loan feature that is popular with investors is an offset account. An offset account is a savings account linked to your loan. The money in the savings account (balance) is offset against the loan amount, thereby reducing the amount of interest you’re charged. You can save a significant amount of money by reducing compound interest with the use of these accounts.
One upside of this option is that you can pay off your home loan faster than the repayment schedule demands while being able to redraw money if the need arises.
However, the downside is that it is not available for all home loans. But when they are available, they usually come in the form of a linked transaction account or savings account.
Another important feature that is often overlooked not just by investors, but by homebuyers in general, is the ability to choose the frequency of repayments.
For instance, if you have a rental property, it is advised to synchronise your repayment schedule with how often you get rental payments from your tenants. If your tenants pay rent on a weekly basis, then your repayment for your home loan should be on a weekly term as well.
While this may not have a significant impact in the short term, it can add up and save you money on your home loan. For example, if your repayment schedule is on a fortnightly basis, you can make an extra month of repayment, given that there are 26 fortnights a year, which is equal to 13 months.
Source: Smart Property Investment
Torrazo, Z. M. (2021, September 23). How to choose the right investment property loan in Australia. Smart Property Investment - By investors for investors. https://www.smartpropertyinvestment.com.au/research/23146-how-to-choose-the-right-investment-property-loan-in-australia