Day 14

Why do investors use and favour interest-only (IO) loans?

The benefit of IO loans is that your repayments are much lower than a principal and interest (P+I) loan. Owner-occupied family homes in NZ are typically on a 25 or 30-year P+I loan, which means that every payment you make is interest payment + principal reduction. Every time you make a repayment on a P+I loan your mortgage amount owing reduces. With IO loans your mortgage amount owed does NOT reduce as you are only paying interest, your repayment can be simply calculated by the interest rate.

IO loans allow property investors to borrow much more as the repayments are more manageable resulting in surplus cash flow that can be set aside for use as the investor sees fit. Perhaps for lump sum repayments on the principal amount, each year or it may be saved to put into another property. IO loans on investment properties are set up because the interest rate expenses are tax-deductible which is not the case if they are set up on the family home.

Check out the Cash Flow for Dummies video on using IO loans for calculations.

Usually, property investors will have only one property at any given time as a P+I loan – most of the time this is the family home for tax reasons and because it is the property most likely to have the best capital gains (nicest house in the best area) in the portfolio.

Each bank has its own standards and rules for IO lending. The accountant will show you the benefits (if your mortgage adviser does not).

This is a video from the Property Formula Workshop. There are several unlocked for you and included in this course. To get access to all videos and spreadsheet calculators please apply for the workshop.

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Does NOT paying off principal mean you never pay off the loan?

Yes and no. You will eventually need to switch your loans off IO and onto P+I because the bank will force you to, and you will not be able to refinance every time. It is common for investors to try and keep their IO loans and switch lending providers to maintain this privilege.

If you buy a $1mn property, get an $800k IO loan and pay 2.5% for it, then let’s look at the numbers.

The rent will probably be around $700/week and assuming 3 weeks vacancy you will get $34,000 annually less the IO mortgage payments of $385/week for a total $20,000yr.

So the property will return a surplus of $14,000 for you to pay rates, insurance and maintenance. There will be a profit in most cases from positive cash flow and potential capital gains.

If you did not use IO loans and used P+I loans the rent would NOT cover all expenses/costs and you would have to be of pocket each year. Repayments would be more than rent.

Access to IO lending probably pushes the market prices up to a point where investors are comfortable with the cash flow and yield positions. Supply and demand metrics come into force and if the banks one day decided that IO loans were no longer available, the number of investors in the market would probably drop and house prices stall. 24% of the total lending in the market is IO lending (statistics NZ).

Why do investors use different tax and ownership structures other than their personal names?

The short answer – profit. When you use a look-through company (LTC) or trust structure, for your investment properties, the expenses are more often than not, tax-deductible. In other words, you keep more of your money.

An accountant with expertise will provide a lot of information and value for your investing. The benefits of loading up the debt onto your investment properties and using the options available will put more money in your pocket – some clients save $10,000+ a year this way. So you spend $1k with the accountant and make a 10x return. Smart money. More information about this is in video 81 of the property formula workshop course – sorry no free preview for that one.

What role does the lawyer play in property investing?

Have you seen the standard sale and purchase agreement? It is long and written in tiny writing. It is hard to understand. When you buy a property or refinance to another bank, there are lots of documents involved for the lawyer to review.

Think of them like the dentist… a necessary evil but ultimately adding a lot of value (if you pull your own teeth or avoid the dentist at all costs even when in pain then good luck to you). Lawyers spot things you will not notice. They are super vigilant. They have a job and that is to protect you. They are not emotional about the investments and are of the mindset to protect your interests even if it means you miss out on a deal.

Do not call the lawyer last, get them involved at a stage where they can help you pull out of a deal easily for justified reasons (if need be) rather than trying to find clauses that are on shaky grounds.

We have only just touched the surface here. There is a lot to it once you start building up the portfolio and we will talk about your A-Team in the coming emails.

Lots of case studies at mortgagehq of families using personal names and P+I loans that literally cost them $100k because they waited so long to fix the mistakes and missed out on building a bigger portfolio because of it. The savings for doing it right, with professionals, far outweigh the costs.

Masterclasses go into more depth

To go deeper and more technical with your knowledge and control over your portfolio and your financial future sign up for $37 for the Mortgage Lifecycle Masterclass.

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Andrew & Blandon

P.S. Tomorrow we get into the meaty part of the meal where we talk about developments and subdivisions. If you do not quite yet understand anything, just let me know, it can be hard to grasp lots of new information and sometimes you just need to hear it explained in a different way.My older video on IO loans is still relevant if you want to have a look.