Navigating the borrowing maze
When choosing the right type of loan to suit your needs now and into the future, there are many factors to consider.
What is the purpose of the loan?
Credit cards provide immediate access to credit that can be used for many purposes, but the interest rate is high so they are best relied on only for short-term loans.
If you need a larger loan to pay back over a longer period, consider a personal loan. These tend to be used for purchases such as holidays or cars.
As the name suggests, a home loan is used for property purchases, either for your own home or an investment. They come in a variety of forms, from the ‘no-frills’ products with low interest rates through to loans offering features such as offset accounts or redraw facilities. Home loans can alternatively be structured as lines of credit that enable a borrower to repay and redraw the loan on an ongoing basis.
If you are planning to invest in shares and managed funds, then a margin loan might be more appropriate, or products with built-in lending facilities such as instalment warrants.
Principal and interest or interest only?
A principal-and-interest loan involves a repayment comprising the monthly interest on the outstanding balance plus an amount that will reduce the principal over the term of the loan.
Under an interest-only arrangement, the borrower pays the interest expense while the loan is held and doesn’t repay the amount borrowed until the end of the term. These loans are not generally provided for long terms. For instance, a homebuyer or investor takes out a 25 or 30year mortgage and repays only interest for the first five or 10 years, after which the property is sold and the loan paid out in full, or it reverts to a principal-and-interest loan for the remainder of the term.
If you’re borrowing to invest, the interest charged on the loan is generally tax-deductible. This means that choosing an initial interest-only loan, rather than a principal-and-interest product, could be simpler for tax purposes and allow you to maximise your deductions over the term that you hold the investment.
On the other hand, using a line of credit facility to buy a depreciating asset, such as a car, could mean that over time you end up owing much more than the item is worth, and pay more interest than a traditional principal-and-interest loan.
Which loan is right for me?
In determining the most suitable loan, look closely at the fees, charges and the interest rates – these can add significantly to the cost of the loan.
Also, remember that you usually pay for any additional features attached to the loan. If you’re not sure, a financial adviser can help you navigate the many choices.