WHAT YOU NEED TO KNOW ABOUT INTEREST ONLY LOANS

An “Interest only loan” is a mortgage where the amount of the loan, known as the principal, is never reduced – the borrower only pays the interest on the amount borrowed.

This means if a person borrowed $500,000 as an interest only loan, the borrower only has to pay the monthly repayments to cover the interest on the amount borrowed.

For example, after five years, the borrower would have paid interest on the loan but the amount of the loan still outstanding would still  be $500,000 because none of the “principal" had been paid off so the loan wasn’t reduced from the original amount of $500,000.

An interest only loan is in direct contrast with the usual “Principal and Interest” loan where the monthly repayments pays both the interest and part of the principal.

This means that after 5 years, the amount of the loan outstanding would have been reduced so also reducing the amount of interest that has to be paid as the loan amount is reduced.

In the 1970’s, interest only loans were popular with both banks and borrowers because property values always seemed to go up so if borrowers did want to sell their property after 5 years, the amount borrowed would not have changed, but the property value would had gone up, so the borrower had made a capital gain without paying off any of the principal.

This all changed in the 1980’s when interest rates rose to 18% and property values went flat.

Today, it appears mainly property investors seem to obtain interest only loans and even then the length of the term can be restricted to no more than 5 years.

However, the investor segment of the property market is growing and interest only loans are growing by 20% a year.

For investors with an interest only loan there are a few inherent problems that may occur during the life of the loan and beyond;-

1. When the interest only period ends after 5 years, what does the barrow do then? Find another bank that can offer an interest only loan?
2. Stay with the current lender and pay higher repayments to cover the interest and principal repayments which may not be able to be serviced from the investment property's income?
3. Sell the property, but it may be the wrong time to sell and the property value could have reduced below the amount of the loan outstanding?
4. Unless the borrower has a fix interest only loan, the interest can go up during the period of the loan so causing financial stress if the income from the investment property doesn’t cover the amount of the repayments.

When considering an interest only loan, the borrower needs to consider what may happen during the life of the loan and in particularly when the interest only period expires.

THE FLOOD OF MONEY FROM CHINA

China's appetite for Australia’s real estate doesn't seem to be diminishing.

Chinese investors bought more real estate in Sydney and Melbourne combined – worth almost $US 3.5M than in London, Paris and New York – this is an Australian record.

The Foreign Investment Review Board approved $12 billion for Chinese real estate proposals in 2014.

It is not only investment in real estate that is growing from China.

By 2024, it is estimated the number of Chinese born Australians would grow from 447,000 to over a million.

NEGATIVE AND POSITIVE CASH FLOW FOR PROPERTY – NEGATIVE GEARING EXPLAINED

With the lowest mortgage interest rates for over 50 years, most investors in property are finding the rental income is greater than the outgoings for the investment so in such cases, the property is known as being “positively geared”.

Negative gearing, as described by Wikipedia, is a practice whereby an investor borrows money to acquire an income-producing investment property, expecting the gross income generated by the investment, at least in the short-term, to be less than the cost of owning and managing the investment, including depreciation and interest charged on the loan (but excluding capital repayments). The arrangement is a form of financial leverage. The investor may enter into this arrangement expecting the tax benefits (if any) and the capital gain on the investment, when the investment is ultimately disposed of, to exceed the accumulated losses of holding the investment.

To service a negatively geared property an investor has to cover the loss created by the shortfall in outgoings compared to the income from the property.

Because an investment property is considered a business, any losses made by the investor can be used to offset the investor’s tax liability from other investments or income.

The Income Tax Assessment Act 1936 - Sect 128b allows a tax payer to reduce their tax liability for their weekly PAYG tax deductions to allow for the loss made from owning a negatively geared property instead of waiting until the end of the tax year to obtain a tax refund.

Capital Gains is the main reason for buying a negatively geared property, so it is very important to buy a property that is negatively geared in an area or suburb where there is every likelihood of properties achieving the highest possible capital growth.

Of course, with a capital gain comes Capital Gains Tax which eats into any income gains made from the sale of a property.

Tax depreciation is an additional tax liability reduction strategy but it is best used for brand new properties which have the highest capital depreciation potential

Properties with the greatest chance of Capital Growth are usually found in suburbs in major cities close to the CBD – within 10 km - or beaches and are the most expensive compared to properties in the outer suburbs, but properties with the highest chance of a capital growth cost more than other properties.

Investing in a property must meet personal needs and the investor investment strategy, age, income, tax liabilities and ability to service a loan must all be considered.

For example, an investor may not consider investing in the Broken Hill property market as a good choice but in a 10 year period an investment property in the “Silver City” produced a rental return (yield) of over 8% and a 10% growth rate. But during these 10 years the property market in that City may have gone through a “catch-up” and that capital growth may not be achieved for the next 10 year period.

Of course, a property can be positively geared if an investor only borrowed 50% of the purchase price, but would be negatively geared for an investor who borrowed 80% of the purchase price because the loan repayments would be higher.

The real problem facing investors with negatively geared properties is the shortfall may grow if the property became un-tenanted or the weekly rent reduced – this has occurred in new suburbs that have been constructed around the fringes of Brisbane and the Gold Coast in the last 2 years.

Another problem facing a negatively geared investor, particularly in the current economic environment, is the possibility of losing employment which may result in the investor having to sell the investment property before achieving any chance of a capital gain.

For these reasons, a positively geared property may be the best investment strategy for most property investors. And if the investor can afford to buy a positively geared property in an area of sustainable capital growth, then the investor has the best of both worlds.

GETTING STARTED ON THE PROPERTY LADDER

It is not easy to get on the property ladder in some parts of Australia particularly in some of the affluent suburbs of Sydney and Melbourne.

First home buyers have to have a sufficient deposit to obtain a mortgage to finance home purchase and then the first home buyer’s income must meet the requirements of the mortgage lender to service the loan.

Add to this is the “once only” purchase costs of Stamp Duty, legal fees, building and pest reports, mortgage application fees and valuation fees and in some cases, mortgage guarantee insurance.

STATE GOVERNMENT FIRST HOME OWNERS GRANT

The Queensland Government provides a maximum non repayable grant of $15,000 to purchase a brand new home or a “substantially renovated home” which is a home that has never been sold or lived in since the renovations had been completed and the building work was subject to GST which has been paid. A typical home that has been substantially renovated could include a "Queenslander" timber house that has been raised to provide additional living accommodation underneath.

Applicants for the grant must be 18 years of age or older, must never have purchase a property before either as an individual or a “couple” to live in but applicants who have purchased an investment property and has never lived in it may be eligible. An applicant must be an Australian Citizen or a permanent resident or and least one of the “couple” is an Australian Citizen or a Permanent Resident. The maximum price of the property cannot exceed $749,999.

Successful applicants must move into the property within one year of completion and live there for six continuous months.

Unfortunately, the Grant is not available if part of all of the deposit for the property is being provided by a person who will reside in the property as a “tenant” so a parent cannot help children obtain a grant on the understanding they could move in with the children.

BUYING AN INVESTMENT PROPERTY AND GETTING A GRANT FOR YOUR OWN HOME

It is possible for a couple to buy an investment property and then purchase a property as a principle place of residence and obtain the First Home Owners Grant providing they have never lived in the investment property.

STAMP DUTY INCENTIVES FOR FIRST HOME BUYERS

The Queensland State Government provides tax and Stamp Duty concessions for First Home owner and details can be found at https://www.treasury.qld.gov.au/taxes-royalties-grants/index.php