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10 min read

Biggest Mortgage Hack! Interest Only vs Interest + Principal

Unlock the secret to a debt-free million-dollar real estate portfolio with our comprehensive guide on interest-only versus principal and interest loans. Understand how to maximise cash flow, make smarter investment choices, and achieve financial freedom. Dive in to discover the strategies that can make you a successful real estate investor.

Written by
Ravi Sharma
Published on
June 14, 2024
How you can get $1,000,000?

Table of contents

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I honestly wish that more people knew this: If we had a common understanding given to us when we were young around debt and how you can retire financially free, we would all be much happier, in my opinion.

In this article, I want to share with you how you can go ahead and get a million dollars in real estate value debt-free.

I'm going to show you in the simplest way possible, discussing interest-only versus principal and interest loans.

 

So if you're interested in what my thoughts are, then definitely keep reading.

Understanding Loan Structures

When it comes to banks and what structures you need to have, I'm definitely not a broker, but I know how this stuff works.

I'm going to share with you my opinion and my take on how you can accelerate your growth in real estate. If you only intend to buy one, two, or three properties in your lifetime, why not make them the best purchases ever and structure them the right way?

PS - none of what I am discussing today is financial advice or credit advice.

When you decide you're going to buy a home, whether it's to live in or an investment property, you'll be faced with one big question: Do I go interest-only or interest plus principal?

Fun fact: When I started investing in real estate, I often scratched my head when I was told “interest-only might be a better option.”

At that point, I thought: This makes no sense, because if I'm interest-only, I don't pay any debt down, and at some point, I want to be debt-free, so how do I do that?

I was always told by people much smarter than me: Trust the process, go interest-only, increase cash flow, and then you can retire debt-free anyway.

I asked them to explain. Well, that's why I create videos on YouTube and articles like this because those people aren't around anymore, and I want to make this information accessible to people like you.

So let's define what interest-only is and what principal and interest are, and then you can decide what move makes more sense.

What is Interest Only?

Interest-only is you going out and just paying the cost of the loan

When you take out debt, you're faced with an interest repayment to the bank.

The bank says: “Hey, I'll give you all this money, but you've got to give me some interest, and that interest is just the cost of borrowing. 

At the current interest rate of 6.5%, the easiest way to calculate this would be knowing your loan amount times 6.5% or whatever rate you're on at the time.”

I'll show you an example in a second and the difference between the two, but it's important to know what the difference is.

That's just interest-only.

You're just paying the cost of borrowing that money, but not the actual balance.

Interest plus principal is exactly that.

Interest is the cost, you're still paying that, but you're also going to pay down that principal. That large amount of debt that you took on, you want to slowly pay that off after every repayment you make.

There's a portion that's a cost, which is the interest, then there's a portion that's your actual debt, the principal, and that slowly goes down over time.

The idea is: If you made all your repayments over 30 years, at the end of 30 years, you'll have a house completely paid off.

However, there are ways to pay it off even faster. I'm going to share with you what would be counterintuitive, and to be honest, at this point, 99% of people who read this article probably still won't do it. That's how the 1% get richer, because they think outside the box.

This is actually quite simple, and the reason why interest-only can get you filthy rich and get you a million-dollar place completely debt-free is because of cash flow.

Importance of Cash Flow

When you go ahead and purchase property, and you're building up your portfolio, what's the one thing that's going to stop you from holding those properties? It's cash flow.

We already know the goal of this game is to hold as many assets for as long as possible. It's time in the market, right? So you want to go out there, accumulate all your assets, and then hold for as long as possible.

The only thing that could stop you from holding is because you can't afford to hold, and that would be your negative cash flow.

Let's say, for example, you go out there and purchase one property in Sydney, and it's negative cash flow by $20,000 a year.

  • If you are out there right now making $100,000, $200,000;
  • Then you’re left with whatever that number is, say, $30,000;
  • $20,000 goes towards holding that one piece of real estate; and
  • You are left with $10,000 a year, which goes into savings.

Could you go and buy a second property like that? Maybe your borrowing capacity allows you to, but on a cash flow basis, you couldn't do it because now you're only left with $10,000.

If you were to take on another property that was negative $20,000, you couldn't do it, right? 

And the same would apply if you actually ended up losing your job. If you had that scenario play out, you lose your job, you can't afford to hold that one piece of real estate costing $20,000, which means you have to sell.

So cash flow is very important when it comes to holding and retaining assets.

Capital growth is super important, and that's how you're going to get rich. But the cash flow allows you to stay in the game for as long as possible.

Interest Only and Principal Vs. Interest in Terms of Cash Flow

Now, I'm going to show you the difference between:

  • Interest-only and principal; and
  • Interest in terms of cash flow.

We will also unveil why these assets you purchase today could mean that you retire a millionaire in the next 30 years.

All right, so I'm here on a home loan repayments calculator.

Home loan repayments calculator

Let's say the amount we're borrowing is $600,000.

Loan amount in 30 years

Over a period of 30 years, if we just went principal and interest and we input our rate of 6.5%, we can see that our monthly repayments would be $3,793.

Monthly repayments

Over the life of the loan, we'll end up paying it off in 30 years, and the total repayments will have been $1,365,267 with the total interest charged being $765,267.

Monthly repayments

As soon as someone watches this part of the video, they'll say: “This is such a dumb idea. Why would I actively go and pay $765,267 to a bank when I can just go ahead and try to pay it off as quickly as possible and be done with it?”

I'll save all those interest costs, right? And that's how the 99% think.

Just bear with me, and if it still doesn't make sense, you can go down that path. But when you see what the numbers look like by doing it this way, you're going to realise why some people end up filthy rich with a lot of money.

Now, if I decided to change this and went interest-only, my repayments would drop by about $500 per month.

Monthly Repayments

Now, it doesn't sound like a lot, but the reality is: that could be the difference between holding one property versus two properties.

So in this example: let's say we did go interest-only and it allowed us, based on our cash flow, to hold one extra property. That means we could buy two instead of one.

Obviously, you have to consider other things like your:

  • Upfront cost;
  • Cash or the equity; and more importantly,
  • Borrowing capacity to purchase the two properties.

Let's assume that you do have the capacity,

And let's assume you have enough of a deposit.

Instead of using a 20% deposit on one property, you use 10% deposits on two properties.

The next part is to realise: How much your property will have grown in the next 30 years.

But before we do that, one of the most frequently asked questions about interest-only loans is: “Ravi, if I'm interest-only and it's for one year or five years, that's the maximum I can do. 

So what happens after that? Do I go interest plus principal?

Well, that's really up to you!

If you decide at that point that you have no intention of acquiring more assets, you can go into debt reduction strategies, start paying off your loan, and even put more money towards it to pay off your loan even faster.

Alternatively, if you feel like you still want to acquire more assets, you can simply refinance and get another five years of interest-only repayments. The term can be changed over once you've refinanced. There are options out there, so don't get scared if you think it's just a short-term thing. There are definitely options out there.

Let's assume we've gone ahead and bought one $700,000 property at an average growth rate of 6% over 30 years.

Calculating the initial investment with 6% average growth over 30 years

What would that actually look like?

Well, we can see after 30 years, that one property we bought, if it grew by 6% every single year and compounded, would now be worth $4 million.

Initial balance projection for 30 years

So we go back to the first example where we spoke about paying $775,000 of interest. If that meant that my $700,000 property is now worth $4 million, it would make sense.

Why? Because I've made $3.3 million, but I paid $700,000 (on top of what my initial investment was). So that, to me, is a pretty fair bet.

Where it gets even better is if I realise that I go interest-only, use my deposits as two deposits rather than one, and it allows me to purchase a second property.

Now, what does that look like? What I've done here is, I've gone ahead and purchased two investment properties at $700,000 each.

Now the initial investment looks like $1.4 million, at a 6% growth rate

Calculation of initial investment looked $1.4 million with 6% growth rate

This means that the total value is worth $8 million now.

Projection of total value for 30 years

Here's the kicker: you still have debt on there, right? And that's what we want to remove.

How to Get Your Property Debt Free?

If we held this for 30 years, you have the option to sell one property for $4 million and pay off the debt on both homes.

If your debt initially to start off with was, say, $600,000 on the first property and $600,000 on the second property, it means your total debt is about $1.2 million.

So if you're getting $4 million,

And your debt is $1.2 million,

Even after taxes and costs for selling, you're going to be able to knock off all of that debt and have one house completely debt-free, which would be worth $4 million in 30 years' time.

Now, obviously, we don't know if the market is going to grow by 6% every year. It could be 3%, it could be 4%, but the reality is: 6% is even lower than what the long-term average growth rates are in Australia. So I'm being conservative here.

So this all makes sense—to be able to hold more assets, and you could do this and replicate this to say: "Well, what happens if I have five properties? What about six properties?"

Well, you'll do the same thing. It might require you to only sell three out of the six, or maybe it's two out of the seven properties, and the rest of your portfolio would be completely debt-free.

Now this is working on 30-year projections. How do I get to a million dollars?

Let's say I only need the properties that I purchase for $600k or $700k to basically get me to a point where I'm left with a million dollars in net equity. Can I get there quicker?

And that's when we come to the yearly breakdown. This means our initial value is $1.4 million, and every year it compounds and increases.

1,400,000 balance with no interest

So in the first year, it grows by $84,000.

In the next year, $89,000.

In the year after, $94,000.

Calculating the compounding growth

And it continues to increase because it's compounding growth. The value of our properties continues to increase.

Compounding growth for 12 years

So what we would essentially do is to try and get a million dollars worth of net equity and be in a position where I could sell one property, knock off all of my debt, which would be $1.2 million.

This means I need to be in a position where I have $2.2 million in equity.

So all I would do is look at my initial balance, which is $1.4 million.

$1,400,000 balance with no interest

And I would look to get $2.2 million in equity, which means I need this number to be closer to $3.6 to $3.7 million.

Now, as you can see, in year 16 to 17 is when I would achieve that point.

Compounding growth in year 16 to 18

At this point, I could simply go ahead, sell one property, pay off the debt on the second property, and be in a position where I have more than a million dollars in net equity in my real estate portfolio.

This is just with one property being sold to hold one.

Imagine trying to do this across three and holding three, or going ahead and building a portfolio of eight or nine properties that are in the right location and grow much faster than 6%.

You can see how easy it is to go down this method and increase your value through your portfolio.

Building the machine is what I've been talking about for years and years.

If you simply say, "Well, I want to pay off the debt,” you should pay off the debt when it's time for you to pay off the debt. 

If you're in accumulation mode, you're trying to take on more debt. So, I would argue that if you're taking on more debt to acquire more assets, why would you pay off your principal anyway?

I hope you learned a lot from this article.

If you need help with buying the right real estate and you think, "I don't want to do this. I don't know how to research, or I just don't have the time,”

Then definitely book a free call with my team at Search Property.

I hope you enjoyed this one and catch you in the next one.

Thanks, guys!

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