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Principal and Interest v Interest Only

Building a Property Portfolio can seem complex at times. There are many decisions to be made.

Such decisions as what type of property do I buy and in which area need to be made. There are strategy decisions to be made and there are issues such as "Whose name do I put on the contract" and how do I structure my Tax.

There are also many decisions to be made on the finance front inclusive of which bank do I use and what type of loan best suits my situation.

One such question, when it comes to finance is quite simply choosing between Principal and Interest and Interest Only.

Conventional wisdom dictates that at first glance Principal and Interest would be the logical option. As the ability to pay down debt and create more ownership (equity) within the property can be a comforting thought although this comes with a higher mortgage payment, which can increase holding costs and potentially impact on an Investors budget.

Conventional wisdom also dictates that Interest Only at first glance may not seem too logical an option. The thought process with some investors may be "Why would I just pay the interest and not make any inroads into the debt and not create equity as a result" to some this seems irrational.

Let's explore why reversing our Conventional Wisdom beliefs may prove beneficial when investing in property.

In order to create logic from a decision to have an Interest Only loan, let's look at it from three perspectives and assuming a $2000 mortgage payment consists of $1600 in Interest and $400 in principal.

Firstly, logic can be drawn from the perspective of maximising Tax Efficiencies. For Example if an Investor purchased an Investment Property and still had debt on the Family Home (referred to as NTE or Non Tax Effective debt) then an Interest Only payment on the Investment Property (referred to as TE or Tax Effective debt) would preserve the Tax Effective debt at the highest rate and not help dilute future Tax Advantages.

This makes sense, but still some people might argue that it still does not address the issue of creating equity. This is true, but can be simply overcome by redirecting the $400 Principal payment as above into the Family Home debt instead. This would comply with conventional wisdom as debt is still being paid off, although Tax Efficiencies are still being maintained at the highest level.

Secondly, logic can be drawn from an Investors decision to be Interest Only, based on the cash flow benefits. A $400 saving as in the example above, may have significant impact on an investor's budget and allow a more suitable cash flow situation as a result. We all have a cost of living and whether that is children to feed, petrol to buy and potentially a bottle of red wine to be purchased here and there, cash flow is important to our quality of living.

Thirdly, an aggressive Investor would see Interest Only as an opportunity to purchase more properties.   For example dependent upon the individual cash flow situation, if the $400 was saved as above, could this be then utilised as the cash flow requirement to invest in another property. Potentially for the same cash outlay as one property purchased Principal and Interest, two could be purchased. The aggressive investor would now have exposure to more growth opportunities and as per a previous column I wrote on property cycles, this may expose the investor to a market at a different stage in its cycle and potentially more growth as a result.

There is no absolute right or wrong to any of the above as careful consideration to an Individuals situation, risk profile and goals is paramount.

Craig Whaley is a Property Analyst and CEO of NPA Property Group.