#### Sim

##### Administrator

**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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