Capitalising interest

When you get your home loan you will often be asked if you want a ‘principal and interest’ loan – where each month you pay interest and a small amount off the principal of the loan. The alternative is an ‘interest only’ loan – where you only pay interest at least for the initial few years of a loan.

There’s a further alternative. You can let interest capitalise. That is you can make no payment and let your loan balance gradually rise. To do this you need a line of credit which does not require regular payments. You also need to make sure that you have not reached the limit of your borrowing – because if you have, the lender will want payment!

Does all this sound scary. It depends. If you watch your finances you might be happy to extend your loan because you believe the asset value of your property is rising. A more important example is where you have two loans – one for your own house and one for an investment property. Interest on the investment loan will generally be deductible, whilst on the home loan it won’t be. In these circumstances it makes sense to have an interest only loan for the investment property and a principal and interest loan for the home loan.

Your investment property finance strategy may include capitalising interest on the investment loan and using the extra cash from not making repayments on it to repay the home loan. The ATO do not allow you to deduct interest on the capitalised interest, however the benefits can still be substantial.

(Remember the statements made above are general. You should check with your taxation advisor what the situation is with respect to your specific circumstances.)