IO vs PI loans

[veebeeseewee]

Hi everyone,

I'm hoping to get my 2nd IP soon after my 1st IP if possible. I've read Jan Somer's book and she prefered IO loan and according to her, I can still build equity and use this equity to buy the 2nd IP. However when I spoke to my broker he said the only way to build equity is to use PI loan and pay extra to the principle whenever I can to speed up the equity size before I can get a second IP. I've seen many people in the forum using/prefer IO loan, perhaps there's a thread in this forum that might have answered my question but I cant find it so far (if yes, can someone please point me to the right thread, thanks).

Can anyone please advice?

Thanks,

 

[lisport]

im no expert but i have put some money into my IO loan before which has built the equity. im thinking of using that to turn my ip into + gearing. currently its - geared.

 

[buzzlightyear]

perhaps there's a thread in this forum that might have answered my question..

Perhaps....

IO v PI

Interest Only Loans

A few more variations will give you a few more threads.

 

[Peter_Tersteeg]

A P&I loan does create equity, but really slowly and effectively only at the rate at which you save the money.

I/O tends to be more effective for investors with a reasonable savings discipline for the following reasons:
1. It maintains the highest possible tax deductions.
2. Allows you greater cashflow which you can divert to further investment or personal use.

You can still create equity the same way or better than a P&I loan by saving the difference into an offset account or a redraw facility. This will save you interest and cashflow. Better yet, the funds are still available if you require them for any purpose and it can be structured to give you the maximum tax deductions even if you use your savings for non-deductable purposes.

If you're no good at savings, a P&I loan can be the way to go. If you're able to budget and save a little money then I/O is far superior.

 

[veebeeseewee]

A P&I loan does create equity, but really slowly and effectively only at the rate at which you save the money.

I/O tends to be more effective for investors with a reasonable savings discipline for the following reasons:
1. It maintains the highest possible tax deductions.
2. Allows you greater cashflow which you can divert to further investment or personal use.

You can still create equity the same way or better than a P&I loan by saving the difference into an offset account or a redraw facility. This will save you interest and cashflow. Better yet, the funds are still available if you require them for any purpose and it can be structured to give you the maximum tax deductions even if you use your savings for non-deductable purposes.

If you're no good at savings, a P&I loan can be the way to go. If you're able to budget and save a little money then I/O is far superior.

Thanks, Peter. But if the offset account requires a $15 maintenance fee each month, will this fee be tax deductible?

Is there any offset account out there that provides interest while I can use it to offset against the loan at the same time?

If I put all my money into my offset account, does it mean it will shorten the period of loan or reduce the weekly repayment's amount?

 

[veebeeseewee]

another question. IO provides the maximum tax deduction compared to PI, but what happen when all the interest has been paid and just left with its principle?

 

[Monopoly]

another question. IO provides the maximum tax deduction compared to PI, but what happen when all the interest has been paid and just left with its principle?

You never stop paying the interest, IO is ongoing for the life of the loan.

However when you want to stop paying IO, pay out the loan then you sell the property (preferrably at a much higher price than you paid for it..aka HANDSOME PROFIT) pay off the principal and have money for your next venture!

 

[Peter_Tersteeg]

Thanks, Peter. But if the offset account requires a $15 maintenance fee each month, will this fee be tax deductible?

Is there any offset account out there that provides interest while I can use it to offset against the loan at the same time?

If I put all my money into my offset account, does it mean it will shorten the period of loan or reduce the weekly repayment's amount?

If the loan is for investment purposes, you should be able to deduct any associated account keeping fees, but this is a question for your accountant.

Offset accounts only offset the loan. They don't pay you interest. Keep in mind the interest on a home loan is usually higher than the interest a savings account will pay. You don't need to pay tax on the interest saving either with an offset account.

The last questions answer will depend on the lender and the loan structure, but the ideal situation is the offset account will reduce your repayment amount if set up properly.

IO provides the maximum tax deduction compared to PI, but what happen when all the interest has been paid and just left with its principle?

As long as you owe money on the loan (which is called 'principal'), the bank will continue to charge you interest, so your statement will never be true.

 

[veebeeseewee]

You never stop paying the interest, IO is ongoing for the life of the loan.

However when you want to stop paying IO, pay out the loan then you sell the property (preferrably at a much higher price than you paid for it..aka HANDSOME PROFIT) pay off the principal and have money for your next venture!

Thanks, Monopoly, I think I can see the point now..

If the loan is for investment purposes, you should be able to deduct any associated account keeping fees, but this is a question for your accountant.

Offset accounts only offset the loan. They don't pay you interest. Keep in mind the interest on a home loan is usually higher than the interest a savings account will pay. You don't need to pay tax on the interest saving either with an offset account.

The last questions answer will depend on the lender and the loan structure, but the ideal situation is the offset account will reduce your repayment amount if set up properly.

Thanks for your advice, Peter.

As long as you owe money on the loan (which is called 'principal'), the bank will continue to charge you interest, so your statement will never be true.

Let's say that's a 30 years loan and it's a $200k loan, they can only charge interest against $200k over a certain period of time only isnt it the case? I'm not convinced the bank can charge us forever, but I'll have to find out further from my broker. But of course that would be nice if I can get more helps from you or anyone here explaining how the interest loan actually works. To my understanding, we'll pay off the interest only first in the beginning of the loan, then it'll be left with principal to pay off in the end.

 

[Monopoly]

Let's say that's a 30 years loan and it's a $200k loan, they can only charge interest against $200k over a certain period of time only isnt it the case? I'm not convinced the bank can charge us forever, but I'll have to find out further from my broker. But of course that would be nice if I can get more helps from you or anyone here explaining how the interest loan actually works. To my understanding, we'll pay off the interest only first in the beginning of the loan, then it'll be left with principal to pay off in the end.

I think you're still confusing the IO and P&I loans. Paying IO you NEVER start paying off the principal, that's what makes it different to a P&I loan where you pay both until the loan is paid out in full.

 

[Peter_Tersteeg]

Let's say that's a 30 years loan and it's a $200k loan, they can only charge interest against $200k over a certain period of time only isnt it the case? I'm not convinced the bank can charge us forever, but I'll have to find out further from my broker. But of course that would be nice if I can get more helps from you or anyone here explaining how the interest loan actually works. To my understanding, we'll pay off the interest only first in the beginning of the loan, then it'll be left with principal to pay off in the end.

The bank will give you a 30 year loan. The first 5 years might be interest only. After those 5 years, the loan will automatically revert to principal and interest with a repayment schedule over the final 25 years. In 30 years you won't owe the bank anything.

Most people make adjustments to their loan within the first 5 years, so the scenario above usually changes.

Some line of credit loans are interest only for the life of the loan, but the loan is for 30 years. In this case the bank expects you to pay a lump sum at the end of 30 years. My understanding is LOCs were 'invented' in the 1990s, so this hasn't quite happened yet and I suspect the banks would be willing to negotiate on how this would actually occur.

 

[Rolf Latham]

I suspect the banks would be willing to negotiate on how this would actually occur.

lets hope so

Some locs, eg Wesuck, have a "repayable on demand" clause.

This is just one reason why many brokers wont use LOCs as the majority debt product in most cases.

I know there are some larger broker and advisory groups that use nothing but LOCs so Id have to assume someone has tested the waters with the legal side of em

ta
rolf

 

[neil100]

A P&I loan does create equity, but really slowly and effectively only at the rate at which you save the money.

I/O tends to be more effective for investors with a reasonable savings discipline for the following reasons:
1. It maintains the highest possible tax deductions.
2. Allows you greater cashflow which you can divert to further investment or personal use.

You can still create equity the same way or better than a P&I loan by saving the difference into an offset account or a redraw facility. This will save you interest and cashflow. Better yet, the funds are still available if you require them for any purpose and it can be structured to give you the maximum tax deductions even if you use your savings for non-deductable purposes.

If you're no good at savings, a P&I loan can be the way to go. If you're able to budget and save a little money then I/O is far superior.

Hi Peter,

what about if you have a fixed rate loan which typically has no offset facility, ( I know some do), would interest only still be the go? And if this were a PPOR would that also change the picture?

Thanks
Neil

 

[Peter_Tersteeg]

what about if you have a fixed rate loan which typically has no offset facility, ( I know some do), would interest only still be the go? And if this were a PPOR would that also change the picture?

Interest only is still available with fixed loans. Most lenders don't allow offset accounts and extra repayments are very limited.

In this case you usually just pay the interest every month and the outstanding principal remains the same. After the fixed period the loan usually becomes variable which opens up your options again.

 

[veebeeseewee]

Perhaps....

IO v PI

Interest Only Loans

A few more variations will give you a few more threads.

Thanks for the links.

The bank will give you a 30 year loan. The first 5 years might be interest only. After those 5 years, the loan will automatically revert to principal and interest with a repayment schedule over the final 25 years. In 30 years you won't owe the bank anything.

Most people make adjustments to their loan within the first 5 years, so the scenario above usually changes.

Some line of credit loans are interest only for the life of the loan, but the loan is for 30 years. In this case the bank expects you to pay a lump sum at the end of 30 years. My understanding is LOCs were 'invented' in the 1990s, so this hasn't quite happened yet and I suspect the banks would be willing to negotiate on how this would actually occur.

Thanks for explaining in more detail, Peter. It does make sense why I can see the banks have 5 years interest only loan. It's only really effective if I dont pay a single cent to the repayment, otherwise it's better off PI loan, looks like I'll have to try really hard to get a positive geared IP now!

I mentioned line of credit to both my broker and my bank before, and they both adviced me to stay away from LOC.

More doubts regarding the offset account. I know it will reduce the interest because it acts like a principle of the loan except that it's more flexible in terms of cashflow. But if that's against an IP and I'll eventually need to use the saving for the next IP, and the interest will go back up to its original (which doesnt affect the minimal weekly repayment anyway). Rather than paying $15 offset account monthly keeping fee, isn't it better off staying in a saving account that will produce me more interest (even though it's taxable, but it's still an income), to top up my saving quicker?

 

[Peter_Tersteeg]

I mentioned line of credit to both my broker and my bank before, and they both adviced me to stay away from LOC.

Agreed, LOCs are generally more expensive than regular loans and don't add any benifit over a properly structured regular loan.

More doubts regarding the offset account. I know it will reduce the interest because it acts like a principle of the loan except that it's more flexible in terms of cashflow. But if that's against an IP and I'll eventually need to use the saving for the next IP, and the interest will go back up to its original (which doesnt affect the minimal weekly repayment anyway). Rather than paying $15 offset account monthly keeping fee, isn't it better off staying in a saving account that will produce me more interest (even though it's taxable, but it's still an income), to top up my saving quicker?

The offset saves you about 7% interest, it's not taxable. A savings account earns you about 5% interest which is taxable, effectively meaning youo'll earn about 3-4%. Whilst the money is in the account, the better value is pretty obvious.

If you're holding more than about $5000, the offset account is far better value for money as this is the point when the interest savings overcomes the cost of the $15/mth fee, assuming the savings account doesn't have any account keeping fees.

When you buy another property, you'll take the money out of the account (either the offset or the savings account), so you'll loose the benefit of either option. In the meantime, you're probably better off holding your savings in an offset account.

 

[THEGREAT888]

hi Rolf

May I have your opinion?

Would it be wrong to say that LOC great way to pay a 10% deposit when purchase an investment property and had no fund available in a saving account/offset account?

T

 

[Rolf Latham]

Hi 888

An loc in this instance is ok to use provided this loc isnt mixed purpose.

Remember that a LOC is just a loan type, nothing more nothing less, and the same rules that apply to loan structurig and for eg tax issues apply to LOC as well, but are a little bit compounded with the issues that are unque to LOC

ta
rolf

 

[veebeeseewee]

Agreed, LOCs are generally more expensive than regular loans and don't add any benifit over a properly structured regular loan.


The offset saves you about 7% interest, it's not taxable. A savings account earns you about 5% interest which is taxable, effectively meaning youo'll earn about 3-4%. Whilst the money is in the account, the better value is pretty obvious.

If you're holding more than about $5000, the offset account is far better value for money as this is the point when the interest savings overcomes the cost of the $15/mth fee, assuming the savings account doesn't have any account keeping fees.

When you buy another property, you'll take the money out of the account (either the offset or the savings account), so you'll loose the benefit of either option. In the meantime, you're probably better off holding your savings in an offset account.

Thank you for helping me to understand, Peter. I was still confused in the beginning because my broker said the offset account doesnt reduce the month to month minimum repayment, but now he said the interest charged on the loan is calculated on daily basis. In that case, it does make sense of having the cash in the offset account. cheers,

 

[RealBus]

There are offset accounts which have no fees, I have one with Westpac. The benefits of an offset are to reduce the interest your paying on your mtg. You would actually earn % your paying on your mtg at say 7% which you'd never be able to earn in a savings account and then you'd be taxed on your earnings.