Lifting the Fog on IO Loans

Some experise needed please!

Having just read Jan Somers 'More Wealth from Residential Property', I understand that her viewpoint is that there is no financial advantage in paying any of the principle off a mortgage – ie why pay tax (on rent) when you can instead enjoy tax benefits, and the “principal” portion of your repayment can instead be put in an offset to be used for deposits on future IPs (ie maximise your cashflow).

My questions are:

1. Won’t an IO IP become CF+ after a period of time anyway (ie over time, as rents increase)?? Meaning that you would have to pay tax on rent anyway?? I am guessing that this would happen sooner in a P&I scenario, though. So aren't you better off 'owning' the whole property (mortgage free) if you have to pay tax on rent eventually anyway?

2. Isn't it possible, when paying off a P&I loan, to refinance at certain points so that repayments are lower – ie making it easier to manage cashflow? Isn't this a benefit that P&I loans have over IO loans?

3. Are the tax benefits gained through negative gearing (on an IO loan) only really substantial if you are in a high bracket income? Are they worthwhile on a lower or more average income?

4. Doesn't a P&I loan – ie paying down the mortgage - offer some insurance against longterm negative equity? Ie because we can't guarantee capital gains on every IP every time (or is that the inherent risk in this 'game'?) If you are paying ‘principal’ into an offset on your IO loan, with a view to using these funds later on to fund other IPs, this won’t insure you against neg equity in the event you need to sell.

I know I have queried IO loans in the past, but I still have questions in my head that I haven't resolved!!! Pliease understand I am not trying to argue that P&I is better than IO - just trying to understand the comparisons between the two so I can see for myself why practically everyone advocates the IO loan.

Your comments most welcome!!

Thanks so much!

suburbangirl said:

2. Isn't it possible, when paying off a P&I loan, to refinance at certain points so that repayments are lower – ie making it easier to manage cashflow? Isn't this a benefit that P&I loans have over IO loans?

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You can also refinance IO loans to lower interest rates, fixed rates, etc. Fixed rates might have a few more fees, but I just refinanced a variable IO with the same bank (higher loan limit) and almost no fees were payable.

suburbangirl said:

4. Doesn't a P&I loan – ie paying down the mortgage - offer some insurance against longterm negative equity? Ie because we can't guarantee capital gains on every IP every time (or is that the inherent risk in this 'game'?) If you are paying ‘principal’ into an offset on your IO loan, with a view to using these funds later on to fund other IPs, this won’t insure you against neg equity in the event you need to sell.

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Technically, yes. But all you’re doing is ‘buying’ that equity in a $1 for $1 ratio. Compare this to using that money to buy another asset.

e.g.
Portfolio 1: $200k IP, $120k loan

Portfolio 2: $200k IP, $160k loan and $40k in CBA shares

What is the difference? In P1 your chances of negative equity are lower, but long term P2 has better growth because you’re getting the growth on the CBA shares as well. Remember that the growth of a property (in the sense of capital gains) is NOT affected by the LVR. The property doesn’t care how much or how little you borrow to buy it. Paying down the loan does NOT increase your future capital gains.

There’s a lot of stigma about neg equity. But the truth is that negative equity DOES NOT NECESSARILY LEAD TO SELLING!!! The bank won’t foreclose as long as you keep making payments. Why would they want to? So, if you use the ‘P’ effectively (buy other properties that go up, shares, etc) then you’ll generate enough cashflow to keep making payments while the market comes back up. Contrary to popular belief, banks do NOT take joy in foreclosing. It's expensive for them. Banks want customers to just hand over the payments every month so they can bundle them into bonds, sell the bonds and lend the money out again.

suburbangirl said:

3. Are the tax benefits gained through negative gearing (on an IO loan) only really substantial if you are in a high bracket income? Are they worthwhile on a lower or more average income?

I know I have queried IO loans in the past, but I still have questions in my head that I haven't resolved!!! Pliease understand I am not trying to argue that P&I is better than IO - just trying to understand the comparisons between the two so I can see for myself why practically everyone advocates the IO loan.

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The purpose of not paying off principal is NOT for the tax breaks. Even at the highest marginal rate of 40%, $1 in interest STILL costs you 60c. So why do it? Because it lowers the cashflow needed to control that asset, so you can buy MORE assets. On $500k in loans, the P payment might be $10k. Does paying down your loan affect the future capital gains of the property? No. But what if you use that $10k to buy shares that pay you more than your interest rate? Repeat that over 10, 20 years.

Or to put it another way, if I didn’t use the principal payments to buy other assets, I would repay the loan. By repaying the loan, you save 7% in interest (actually, 4.2% at the highest marginal rate). By using that money to buy another asset, you pay 7% in interest but get x% on the new asset in return.

I think you’re too stuck on the tax benefits of IO. That’s not the only purpose. The purpose is MANAGING YOUR CASHFLOW SO THAT YOU CAN CONTROL MORE ASSETS. Note I used the word ‘control’ instead of ‘free and clear ownership’. It’s a day to day version of the theory ‘would you rather own a whole grape or half a grapefruit’.

Bottom line: With good money management, IO frees up more cashflow to invest in other assets that increases your portfolio. P&I decreases your cashflow, which decreases your ability to buy other assets and decreases your future portfolio.

The key point is that mortgage repayments only have a return = interest rate. You don’t get any extra capital gains because the IP is yours anyway. Buying ANOTHER asset means you get MORE compoundable returns. Negative equity is a psychological point: it has almost no practical meaning, as long as you make the payments. As long as you make the payments and your cashflow is ok, you won't be forced to sell.
Alex

Hi Suburbangirl,

I've answered what I can in your questions below (I'm not an accountant lawyer, mortgage broker by the way)....

suburbangirl said:

1. Won’t an IO IP become CF+ after a period of time anyway (ie over time, as rents increase)?? Meaning that you would have to pay tax on rent anyway?? I am guessing that this would happen sooner in a P&I scenario, though. So aren't you better off 'owning' the whole property (mortgage free) if you have to pay tax on rent eventually anyway? Yes, having an IO loan increases your cashflow - but it won't become CF+ any sooner than with a P&I loan, because the Principle is never deductible (so if you pay $200 interest a week, and your rent income is $200, it's totally deductible - if you pay P&I of $300 - $200 interest, $100 principle, $200 is deductible, the extra $100 for principle comes straight out of your pocket and is not tax deductible, even if you were receiving $300 rent - that extra $100 in rent would be subject to tax)

2. Isn't it possible, when paying off a P&I loan, to refinance at certain points so that repayments are lower – ie making it easier to manage cashflow? Isn't this a benefit that P&I loans have over IO loans? Yes, but you can refinance IO loans as well, and if you want the repayments to be lower, you can always shift the funds from your offset account into the property

3. Are the tax benefits gained through negative gearing (on an IO loan) only really substantial if you are in a high bracket income? Are they worthwhile on a lower or more average income? This depends on the growth in the property, as well as the type of deductions (eg. cash free deductions such as deprecition - worth it no matter what you tax bracket)

4. Doesn't a P&I loan – ie paying down the mortgage - offer some insurance against longterm negative equity? Ie because we can't guarantee capital gains on every IP every time (or is that the inherent risk in this 'game'?) If you are paying ‘principal’ into an offset on your IO loan, with a view to using these funds later on to fund other IPs, this won’t insure you against neg equity in the event you need to sell.Yes, it does - but if you put the money into an offset account you are serving the same purpose - presuming you know how to save and don't spend the money on "bad assets" - if you are truly worried about negative equity you can (rather than putting in Principle), put the money into an offset that you vow to treat the same as principle, and therfore do not use the funds, but they are still readily available (and the interest will remain tax deductible) if you need them

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Cheers,
Jen

Suburbangirl, going at it from another way, what are you concerned will happen with using IO vs using P&I? I can see you're concerned about using IO, but I'm not sure what.

What do you think is the worst case scenario with using IO that you believe will not happen with P&I? If we approach it from that direction maybe we can address your concerns more directly.
Alex

By the way - I think IO loans, for people who do not manage their money wisely - are pointless (eg., our cousins - they would spend the extra cash on the most useless crap you could find, and pay top dollar for it).

While I think it's a fantastic tool to increase your cashflow, and allow you to purchase more and more fantastic investments - it can also have the opposite effect of spending that money on useless nonsense, or just spending more because you have the extra funds. I really don't think it should be used by people who are not interested and educated in investing.

Cheers,
Jen

Yes, IOs are useful ONLY if you put the principal amounts towards other assets or savings. If you can't control your spending, go P&I.
Alex

Smart questions sg
Good replies Alex and Jen....agree with all you say....

I can understand the reluctance to go IO. When you are new to IPs sometimes it can take a while to get comfortable with having large amounts of debt that you are not paying back.

If you don't feel comfortable with IO, by all means go P&I. You will find that if you want to have more than a couple of IPs you will slowly change your ways.

Our first couple of IPs were P&I. We were on a low income too so were really concerned about the amounting debt added to the fact that we didn't have anyone to help mentor us. I discovered this forum, & property prices started to go up, so we wanted to buy more. To do this, we had to go IO. Best thing we did.

You are starting out with so much more knowledge than we did. I'm sure you will do well no matter which way you choose to go.

at the end of the day i find the amount of debt we have is irrelevant - if fact i couldn't tell you a dollar amount without getting out the paperwork and adding it up, except to say that is somerwhere over $2mil.

what is very important is the money coming in and the money coming out (cashflow). interest only allows me to have more money coming in, and hence allows more money to go out ... in io mortgage payment on additional ip's.

by having more ip's i am able to take advantage of cg over a wider array of properties - so when the market goes up i get a greater percentage of cg.

i hope that makes sense.

suburbangirl said:

My questions are:

1. Won’t an IO IP become CF+ after a period of time anyway (ie over time, as rents increase)?? Meaning that you would have to pay tax on rent anyway?? I am guessing that this would happen sooner in a P&I scenario, though. So aren't you better off 'owning' the whole property (mortgage free) if you have to pay tax on rent eventually anyway?
Your comments most welcome!!

Thanks so much!

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Comes back to strategy.

For us, our IP's are seen as "Capital Growth instruments" not "Income".
So there is no real benefit in owning a mortgage free property - as the equity would be "dead money". That equity can work harder for us in other ways - eg in another property, or shares, or whatever.

Our intention is that our IP's will never become CF+ as we will keep drawing down the equity as the value of the property grows (lenders permitting! )

Let's face it, if you pay off your propoertis, how on Earth would you meet the ultimate goal of "dying in debt" (preferably to the tune of 10 digit figures )?


Cheers,

The Y-man

The Y-man said:

Let's face it, if you pay off your propoertis, how on Earth would you meet the ultimate goal of "dying in debt" (preferably to the tune of 10 digit figures )?

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hehehe......glad you mentioned that Y.....has given me new impetus and perspective on tweaking my strategy to include karking it in debt......I now have new found enthusiasm that if growth is slow til I die, as Con the Fruiterer would say, "doesn't matter"....

First up, thanks everyone for your replies. I hadn't had a chance to get back in here till tonight, been busy with the little one and fixing up the garden!

I think I was possibly a bit misunderstood when I asked:

2. Isn't it possible, when paying off a P&I loan, to refinance at certain points so that repayments are lower – ie making it easier to manage cashflow? Isn't this a benefit that P&I loans have over IO loans?

I actually meant this as, once some of the P&I loan is paid down, refinance so that the minimum repayments are lower, hence giving you more cashflow. I didn’t just mean refinance to get lower rates (which I do know you can do for both P&I and IO).

I do understand that with an IO loan you have more cash free to use for further investment, but what I think my 'problem' is with this is, is that I can't see that it really would be enough of a significant amount to make a difference (ie to plough back into additional IPs, as shares really aren't my thing). When Alexlee gave the example of $500k in loans, with the principal payment being something like $10k, I was thinking in the big scheme of things - IP-wise - it wouldn't really make that much of a difference. So, I can't see the point in not just paying the P&I and having the 'safeguard' of at least having paid some of the loan back in the event of longterm negative growth in a situation where you had to sell.

Alexlee (very smart guy!!) also said he could see I had concerns with IO loans, but couldn't pin it down to a worst case scenario. I guess a worst case scenario, for me, would be exactly the above - ie longterm negative growth in a situation where you had to sell (not because of the bank but perhaps because of other factors like bad tenants, vacancy, loss of jobs or whatever all happening at once - rare, but it sometimes happens!!). Where you had a few IPs, perhaps negative growth wouldn't be such a concern because capital growth in your other IPs might make up for this, but with your first IP, I think it is probably more of a risk. Anyway, that's my take on it.

Someone else suggested simply using an IO loan and putting the principal component into an offset - which would in effect solve that 'worst case' scenario - leaving the money available to use further down the track when I perhaps had other IPs to lessen the risks. Which makes sense to me.

I guess I am thinking out loud a bit. When I first came to this forum, I was just looking for general information about perhaps getting a (ie: one) IP. Actually, I had never heard of the term "IP" or "PPOR" or pretty much anything really. I started reading this forum, which really sparked my interest; then started reading lots and LOTS of property investment books and before too long realised that there were many, many more opportunities open to my hubbie & I than I'd previously thought. So I am trying to learn as much as I can as I go, and basically querying anything and everything so I am clear in my mind as to how everything works and what to do when we're ready to make our move.

My hubbie & I have invested in the past, but I'm embarrassed to admit how lucky we were versus how knowledgable we were! Next time round, I want to do things very differently.

Anyway, if you have read this far, congratulations! I think because IO loans are so completely opposite to everything I know about paying down debt, even when I can see the benefit on paper, it is still a little difficult to get my head around it.

Oh, and one final query! If you had an IO loan, and you decided to pay the principal component into an offset account (and this may sound like a silly question...!!) - but how would you know how much 'principal' to put in? Because with a normal P&I loan, doesn't the principal increase, as the interest decreases?? If anyone can enlighten me on this, that would be fantastic.

Once again, thanks to everyone who's taken the time to reply. Grateful novice says a HUGE thank you!!

suburbangirl said:

I do understand that with an IO loan you have more cash free to use for further investment, but what I think my 'problem' is with this is, is that I can't see that it really would be enough of a significant amount to make a difference ...
Once again, thanks to everyone who's taken the time to reply. Grateful novice says a HUGE thank you!!

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Hi Suburbangirl,

I just reread the whole thread again (well skimmed thru it... ) and I am not sure if the following point was made clear:

It's not the cash that it frees up - it's the differece in the loan amount that becomes available to you, from the bank based on their serviceability models.

Try any of the bank "How much can I borrow" calculators.

In the box that asks for "what are your current repayments" - if you are paying PI, you must put in the entire PI figure (not just the interest component of th repayment). So even if a $200 repayment is $100 interest and $100 principle, the bank still sees this as $200 coming out of your pocket.

Compare how much you can borrow from the same bank will all other criteria left the same, except changing the repayment figure to an IO one - the difference can be staggering.

Hoping this helps.

Cheers,

The Y-man

Thanks Y-Man - I was looking at it in a different way. And yes, I can see that the bank would be willing to lend a LOT more where your repayments were IO versus P&I. And this would make a significant difference in what you might be able to purchase...!



So if you were going to go P&I, you'd do it with an IO loan, and the principal component in an offset...that way you only need to 'declare' IO commitments to the bank, who will then provide you with lots more money to 'play' with!

Got it!!!

suburbangirl said:

Oh, and one final query! If you had an IO loan, and you decided to pay the principal component into an offset account (and this may sound like a silly question...!!) - but how would you know how much 'principal' to put in? Because with a normal P&I loan, doesn't the principal increase, as the interest decreases?? If anyone can enlighten me on this, that would be fantastic.

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SG, let's see if I can spell it out clearly.

Compare an IO with 100% offset acct, with a PI loan, for the same principal borrowed.

If you make the same monthly pmt for each loan, then after 3, 5, 7, 10 years, your interest component and principal component will change at the same rate.

Why? because for each loan, as time passes, interest component decreases, and principal component increases equally.

The only difference between the two loans is that in PI, the bank owns the principal component, and you must now borrow it back from the bank on its terms. With an IO loan, you own the principal component and can do with it whatever you want without the bank's permission.

Check the P&I loan worksheet on this spreadsheet, and realize that for the same monthly pmts, "interest charge for period" decreases and "principal for period" increases equally for both.....

However ....................

Most lenders take their own debt as PI over 25 years if you take an IO option.

Even better some lenders take other banks debts yiu have as PI regardless of what they actually are.

Got to line up your ducks by spending some time with a good independent broker.

If you are afte max borrow cap, dont waste your time chasing lenders direct - they have no clue what the next lender will do.


Ta
rolf

interestingly the westpac guy I am seeing tomorrow admitted he was an independent broker pre wbc. I was too polite to enquire why he now works for wbc.....

this is the same guy that told me wbc don't do lo doc offsets....will be an interesting meeting......

must have been my week for getting bum advice.....my acct told me that if I flicked the IP duplex, at any time after construction completion, then I wouldn't be up for GST....hence there was no need for me not to agree to buy house on the margin scheme....

I voiced my concern that it would be considered a speccie, and that I needed to hold it for at least 5 years as a rental to avoid GST....