IO or P&I ? A technical analysis ! (very long)


From: Sim' Hampel

After a discussion the other day with someone about the time value of money and the effects on IO loans versus P&I loans, I decided to do some analysis.

I have made up a spreadsheet in Excel that calculates the Net Present Value of a stream of loan payments.

First some definitions:

Net Present Value (NPV) - the current value of a series of future payments or income after being discounted by inflation.

In other words... the NPV of a series of loan payments is the equivalent amount in TODAY'S money that you must pay to equal the same amount spread out over the life of the loan.

The reason such an analysis is important is that there is an argument that by using interest only payments, you can effectively defer your loan principal repayment until sometime in the future, when inflation has reduced the effective cost of your payment.

For example, if you have a loan for $100000, and you take an interest only loan, you are not required to pay back that amount until some time in the future.

Say you take out a 25 year IO loan (or sequentially refinanced shorter IO loans to an effective 25 years), then at the end of that 25 years, you still owe $100000.

But the $100000 you pay back to the lender in 25 years time has decreased in value due to inflation.

The argument is that deferring the payment of the principal of the loan for as long as possible will let inflation reduce the REAL value of that principal to the point where it is trivial to pay it back (for example, $100000 may be only a couple of weeks worth of wages in 25 years time).

My counter argument at the time of the discussion was that for the privilege of borrowing money, you must pay interest on that loan. I guessed that the cost of interest payments would outweigh the discount from inflation.

I decided to create a spreadsheet that shows three examples:

1. 25 year Interest Only loan, paid annually in arrears, with the principal paid in full at the end of the 25 years.

2. 10 years Interest Only loan, paid annually in arrears, followed by 15 years Principal and Interest, paid monthly in arrears, with the principal paid out in full by the end of the 15 years.

3. 25 years Principal and Interest loan, paid monthly in arrears, with the principal paid out in full by the end of the 25 years.

I used MS Excel 2000 with the Analysis Toolpack installed so I could use functions like CUMIPMT (Returns the cumulative interest paid on a loan between two periods in time) and CUMPRINC (Returns the cumulative principal paid on a loan between two periods in time).

I also use the NPV function in Excel, which calculates the net present value of an investment by using a discount rate and a series of future payments (negative values) and income (positive values).

In my example spreadsheet I use a principal amount of $100000 although this is arbitrary. The percentage differences between the three loan types are the same regardless of the amount used.

I also use an interest rate of 8% and an inflation (or discount) rate of 3%. Again, these are arbitrary, but the size of the differences between the loan types are dependant on these two variables.

The net result of my analysis is that when interest rates are higher than inflation (almost always the case in our economy), then the NPV (or net present cost in the case of a loan) for an IO loan is higher than for a P&I loan. This means that it is more expensive in REAL terms to have an interest only loan.

Note that if interest rates and inflation rates were the same then there would be effectively no difference between IO and P&I loans in my analysis. The only reason my spreadsheet shows a difference (if you were to adjust the rates yourself to be the same) is that there are some benefits to be had from paying P&I monthly rather than annually (it would be even better to pay some principal fortnightly or weekly).

Anyway, as you can see in the spreadsheet, with the IO loan over 25 years, we discount the $100000 to only $47760.56 by deferring payment until the end of the term. However, there are constant $8000 per year interest payments which make a total of $200000 in interest over the 25 years, which is discounted to $139305.18 in today's money. The total outlay then in today's money is $187065.74.

Compare this to the P&I loan over 25 years. The $100000 in principal is only discounted to $61891.78 because we start paying principal in year one. But because we do pay the principal as we go, the total interest bill is only $131544.87 which is discounted to $99385.22 in today's money.

The overall result is that our total outlay in today's money on IO is nearly 10% more than if we did P&I payments.

The other example of 10 years IO followed by 15 years P&I is results in a total outlay of $170109.68, which is in-between the IO only and the P&I only results, as we would expect.

In summary, I found that whenever interest rates are higher than inflation rates, which is almost always the case in our economy, then Principal and Interest loans (and indeed paying as much of the principal off as possible as early as possible) will result in less money spent overall in real terms.

Note also that attempting to postpone the principal repayment indefinitely until a time in the distant future when the principal is a miniscule amount will not improve the situation, (assuming that you will be paying interest for the duration of the loan), as the ongoing interest bill will wipe out any discounts received from inflation.

Now, to give a bit of balance to this analysis, I would just like to mention that IO loans do still have a useful place in society when we consider other variables conveniently ignored in this analysis.

For example, by using IO we can maximise cash flow from an investment in the short term, which may then be put to other uses.

Accelerated principal repayment in the future can offset many of the losses incurred during this time. Capital gains may also assist if we sell a separate property and use those funds to pay down part or all of this loan in a lump sum.

There are many other factors not considered that may also affect the outcome, but I think my point remains valid in most cases.

If anyone cares to comment on this analysis or the spreadsheet, I would be glad to receive the feedback. If you did not understand any part of the analysis or discussion, then I would gladly elaborate.

Hope you found this as enlightening as I did !

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Reply: 1
From: Duncan M

>For example, by using IO we
>can maximise cash flow from an
>investment in the short term,
>which may then be put to other

For me, this is the key point. The ability to gear into more property, the growth on which outweighs the loss sustained by staying at IO for the first x years..


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Reply: 1.1
From: Donna Larcos

I must say the cashflow is more important
for me too. I am (shock, horror) a negative
gearer and $2-3000 in capital
repayments is enough to control another
property. $100,000 property for ten or so
years at 10% p.a. in Sydney very quickly
makes up for the lost interest. I actually
don't intend to pay down but rather control
more and live off the equity (which I've
actually been doing for the past five years
or so). This wasn't intentional but my
husband decided to go back to studies
and has been only working 3 days a week
for the past five years. But the properties
are rising faster than I can use the rising
equity. This way I can include my house
as an "asset" in that it gives me rising
equity as well. The way I see if, I can
leave the kids with say a $3,000,000
property portfolio with $1,500,000 in debt
because it will be rising at roughly
$300,000 p.a. which to me is better than
owning outright 3 properties, valued at
$750,000 giving me $60,000 in rent on
which they have to pay tax. There will be
land tax of course..... or am I naive? It's
been working well so far.
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Reply: 2
From: The Wife

But Sim,

Which way are YOU using?

~Life is a daring adventure, or nothing at all~
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Reply: 2.1
From: GoAnna !


He may want to buy one of your don't be mean to him!

GoAnna !
(aka Anna before she got real)
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Reply: 2.1.1
From: The Wife

I'm not being mean :eek:)

He has obviously analyzed it,and
I just wanted to know what the final outcome is, which way he is going to go?

~Life is a daring adventure, or nothing at all~
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IO or P&I ? A technical analysis ! (very short)

Reply: 3
From: GoAnna !

I am a woman that operates from basic principles

The important issues to me are


cash flow

peace of mind

In order to maximize my growth I need to be sitting on as much property as possible. I am currently limited by my repayments so I need to keep them as low as possible...hence IO.

It is important to me that my properties are giving me as much cash to live off per month as possible. Again interest only is the answer as this minimises my outgoings.

In order for me to sleep at nights I need to feel sure that I can comfortably meet my commitments and that I am growing in wealth. Just because i have only undertaken to pay interest only doesn't mean that I can't make extra repayments whenever i wish. But the bank does not expect this of me and give points for exceeding my promises.

I guess the "real cost" of the loan is of little interest to me. Afterall my tenant and the taxman is paying for it not me!

In terms of paying out the loan you could either

* never pay it out (don't tell my bank!)

* sell and pay out debt (IO repayments would have allowed you achieve greater capital growth)

* use rent to reduce debt

* pay in any additional monies you have

But the amount and timing would be at my pleasure. : )

GoAnna !
(aka Anna before she got real)
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The Taxman doesnt cometh bearing gifts..

Reply: 3.1
From: Duncan M

>I guess the "real cost" of the loan is of >little interest to me. Afterall my tenant >and the taxman is paying for it not me!

Whoops Anna, you pressed the big red button..

The taxman is NOT helping you pay for it.

This is the flow:

1. You earn money, some of this money goes temporarily to the Tax Office, some goes there permanently.

2. You complete a Tax Return.

3. The Tax Office gives you some money back that you have overpaid.

I fail to see how the Tax Man helps anyone pay for their property.

Dont confuse the fact they you're allowed to deduct expenses associated with earning your income from your Gross Income as being 'helped' by the Tax Office.

The view of the ATO as being some benevolent giftor of funds to Real Estate Investors is a view that is much endeared and promulgated by shonky marketing companies..

You need to develop a much more fundamental understanding of Tax.

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Reply: 3.1.1
From: GoAnna !

Hi Duncan

I understand your point of view and share it to the extent that i never ever ever buy a property because of the "tax benefits".

I focus on wealth creation and income.

However "paper" losses such as building depreciation can greatly improve cash flow and hence "help" me pay the loan. I am here referring to a property that is cash flow positive before any tax adjustments are taken into account.

Without that property some of my tax would have gone to the big back hole in the tax office never to be seen again. : (

GoAnna !
(aka Anna before she got real)
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Reply: 2.2
From: Sim' Hampel

Very good point TW... after some discussions late last night on the chat room, I was going to follow up with a rebuttal to my own post (I'm good at that !) basically outlining some of the points that GoAnna has already raised.

As to what I use myself... nothing, as I am currently debt free !! (just thought I'd boast about that for a second).

Anyway that is about to change as we put some of our equity to use, so I will answer the obvious next question "what am I GOING to do ?".

Well... that's a good question.

My first couple of properties will most likely be high value and positively geared. My goal for these properties will be for them to provide me with cashflow to live on (and for other investment).

I haven't actually decided on the details of my strategy with loans. After this analysis, I am considering P&I as an option, as the properties will produce sufficient cashflow to cover a P&I loan, and growth may not be fantastic.

Anyway, I'll let you know what I decide. I certainly agree with GoAnna that there are more issues to consider that what I just discussed in my analysis.

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From: Duncan M

>However "paper" losses such as
>building depreciation can
>greatly improve cash flow and
>hence "help" me pay the loan.
>I am here referring to a
>property that is cash flow
>positive before any tax
>adjustments are taken into

I'm unsure of the exact technical definition of depreciation.. My understanding is that you're essentially getting a credit against a future expense.. At some stage that hot water service you're depreciating will have to be replaced, this will cost you real money..

The concept of non-cash deductions is, again, not some benevolent move by the tax office.

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Reply: 3.1.2
From: Apprentice Millionaire

Fair point!

What Anna did say is that the tenant is paying for the loan, at least in part, and I would guess that IP investors would aim at maximising that part. Comes back to my leitmotv of insisting on cashflow positive IPs, and that an investment should show high return (yield and growth) irrespective of tax advantages.

Having said that, I concur with Anna in her reply, in that if I was not able to a certain extent to lower my tax bill through property investment, I would have found it harder to start on this journey to wealth. In that respect, the taxman is indeed 'helping' me as he allows me to make deductions, which in turn lower my tax bill. Or maybe I should rephrase that: the legislators are helping me as they have instructed the taxman to accept my deductions!

Apprentice Millionaire
(aka Jacques in the old forum)
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The Taxman doesnt cometh bearing gifts..

From: Ian Findlay

Hi all,

Does the taxman "encourage" us to increase our wealth? Well yes and no . .

No - he takes too much both in direct taxes and indirect taxes. Consider you want to buy something costing $100. That is $100 in after tax dollars so it takes almost $200 to buy it (tax ~$100). You pay $15 GST so the real value is $85, the retailer pays GST on his supplies so $72. So to buy something with real value of $72 it takes $200 - 74% tax.

Does he give back well yes. He allows you to effectively claim rebates with the costs of increasing wealth i.e. claim paper losses from depreciation etc. In effect he is subsidizing your own wealth creation - which I believe is a great idea - encourage people to be as self-reliant as possible.

I would also argue that interest from deposit accs should be non-taxable as its triple dipping. You pay tax to create the investment, its taxed when its in there and its taxed again when you spend it.

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Reply: 4
From: Michael G

Hi Sim,

Great viewpoint, mind if I add some of my own thoughts?... ok thanks.

Ok, you note that the difference between IO and P&I is about 10% in P&I's favor. Which basically means a portfolio of $1mil means your $100,000 behind the game, if paying IO.

I guess it all comes down to disciplines. The one big advantage of IO is the smaller repayments (compared on a weekly basis). This means your expenses are effectively lower.

The point here is, ONLY if one is disciplined does this help. I mean there's no point saving $50 a week if you are going to use it to have nice dinners each week. That $50 must be re-invested back into investments to be of any good (for newbies read "The Richest Man in Babylon").

So its all about leverage, IO loans give you the extra cash to leverage further into more property.

But there is a risk, leverage increases your debt, and thus increases your risk if rates balloon. So its important to work within margins. Basically if can you afford a 2% increase in rates, which may give you enough time to fix if necessary.

So to going back to your analysis, what if we were to assume that every dollar saved between P&I and IO repayments were invested, and used. I guess the assumptions to be made would be;

1) that each $1 can leverage a certain amount (after paying purchase costs). I.e. if deposit is 10% and purchase costs are 6%, then every $16 dollars saved can leverage another $90.

2) that once invested, the total investment will grow at a annual rate say 5% conservatively, I.e. $100 grows to $105 1st year, etc (5% would be net growth, after expenses [interest, rates, maintenance, etc]). The cash-on-cash return would then be $5/$16 = 31.25% (net income/over capital outlay), [if Ive gotten this wrong please tell me].

This is the main goal of someone using IO, the ability to leverage their money the best possible way.

Sim, would you be able to factor such calculations into your spreadsheet? I'd be interested to see the comparisons.

One last thought I've had. Its looking at this like a business. My view of businesses are that they either are growing or dieing. And their main concern is cashflow. Which is why many businesses lease equipment. Sure they can buy a truck, but leasing reduces the short term payments, which allows them to afford to lease two trucks that can bring in twice as much income. If we think of properties as just "vehicles" in a property company. The more we have the more "$"'s the can deliver to us (I think I butchered that analogy, but I think I got my point across).

You're home is your possession, so keep it and treasure it, IPs are just tools or equipment we use for wealth, get as many as possible so they can work for YOU.

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The Taxman doesnt cometh bearing gifts..

From: The Wife

ummmm...with the tax man....I'm a realist, I'm following Duncans point of view.

Paying tax and claiming some back, or claiming deductions, its really just shuffling money from here, to there, for this reason or that.There is no 'gifting' from mr ATO.

~Life is a daring adventure, or nothing at all~
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From: Garry T


I'm not an accountant so correct me if I am wrong but I don't think you are entirely correct.

My understanding is that the retailer claims back the GST paid from the taxman, just as a manufacturuer would claim back the GST paid on raw materials. The GST system eliminates the situation where sales tax was paid on whole sales tax, ie a tax on a tax. Hence the 10% is effectively only paid once and that is by the consumer who is not using it as an input for their income producing output.

Otherwise the case occurs where a complex object that requires inputs to go through many stages and seperate businesses could easily become 90%+ tax and <10% value added. On the other hand a large manufactuer that is able to create the same object completely in house would only add GST on the output.

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Reply: 4.1
From: Felicity W.

Interesting stuff...
My feeling is that if we can use money that would otherwise be disappearing permanently into the ATO's coffers to help build our wealth assets, I'm all for it!
Maybe it's not a gift, maybe they're not technically paying for it, but I figure that it's a lot more beneficial to build wealth than pay more tax.
Mind you, my plan is to have a huge tax bill one day - because that will mean I'm earning an ultra huge income!
Although by then I'll probably pay lots of money to an accountant to make sure I only pay a moderately huge bill.

Keep smiling
Felicity :cool:
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Reply: 4.1.1
From: The Wife


~Life is a daring adventure, or nothing at all~
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From: GoAnna !

I think that in Australia we are blessed with a tax system that allows us to treat property as a business and to offset losses against other income. For most people this decreases out of pocket expenses and allows them to buy more properties. In this way the Australian tax system helps/supports the purchase of investment properties.

Other tax systems are less favorable. Perhaps Jeremy and Ian would have something to add here as i understand you both have experience with overseas property.

Regardless of how you call it at the end of the day our current system can improve our cash flow position.

Duncan, please correct me if I am wrong.

GoAnna !
(aka Anna before she got real)
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From: Robert Forward

Sorry Goanna

I don't agree with you there.

If you sit back and view IP's from a different outlook you will see that it has done large damage.

Other may not agree with this view but that is your choice.

Simply because of the governments Negative Gearing laws investors are now willing to accept buying assets that "loose" them money. These very same Negative Gearing laws have allowed these 2 tiered property companies to start up and run riot through the inexperienced investors.

Now imagine if these laws weren't around. Wouldn't the government have more money to spend on the populace (as well as themselves) and the country may not be in so much debt. And if these laws weren't around would you accept/purchase an assets that was going to loose you money, my guess is that you wouldn't. So the government with these laws are stifling real investing and making real money.

But that is my thought on the situation. I'd like to hear from others about their opinions in regards to the above.

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