is going P&I on IPs *always* bad?

[slower_learner]

Dear all,

Been thinking too much about this and would appreciate the perspective of others. I was always told that paying off IP debt was in effect counter productive as it wasn't tax efficient. My understanding of this is: (i) it is only the interest on investment loans which is deductable, (ii) any money spent paying down debt could probably be invested for a greater return, and (iii) if money used to pay down debt has already been subject to tax it is costing you a great deal more to reduce the loan. Hence IO loans are the most prevalent type of IP financing (and I suppose P&I makes servicing a bit harder).

The benefits of negative gearing just reinforces the reasons of never paying off the debt. About the only rational argument for paying down IP debt I've seen mentioned is SANF.

My situation is slightly different from the norm, so I wonder whether I should follow the crowd. I'm currently in the UK but planning a move back to Oz. I have two properties and hope to keep them as IPs. The UK doesn't allow negative gearing.

On IO basis both IPs would be +ve geared
On P&I basis one IPs would be -ve geared, the other neutral.
(Assuming rents increase it will only take a short while for both to be +ve geared. I've factored in all major costs in these calcs. Details if people want them.)

I think I would be justified in setting up my IP loans as P&I as:
1) there is little difference between P&I and IO payments. As the rents almost equal the mortgage payment I might as well pay it off. It's too small an amount to be useful...
2) the rental income would be my UK total income according to Inland Revenue. After I deduct interest payments this amount will be very low (at the start of the loan). This wouldn't be the case if I was resident in the same country as the IPs.
3) In 25 yrs they'd be debt free AND the combined value will be considerable.

This appeals as I can let the UK 'pay for itself'. I won't need to send money back which is my silent fear.

Questions:
1) Does the above makes sense? Under what circumstance would paying off IP debt make sense?
2) Am I right in thinking that the meagre amount that it is (rent - interest payments) will be of interest to ATO (even though this will be less than the taxable allowance in the UK)?

I'm really asking the second question in vain. I think I know the answer.

Thanks for any insight you have,

slower_learner

 

[alexlee]

The purpose of not paying the P portion is to use it more efficiently (to service more debt, to use a deposit for more IPs).

Whether you pay off the P portion or not doesn't affect the future growth of the property: you'll still have a chunk of equity in 25 years. Say you buy a London place for £200k now. In 25 years, it'll probably go up 5 times (approx 7% increase). In 25 years you can either have a £1m property with no debt (if you pay off the principle) or a £1m property with £200k debt (if you go IO). That's not much of a difference, especially if, over the years, you've used that £200k you didn't pay in principle to buy other properties that have also grown.

The key is this: that amount that you would pay in principle: what are you going to do with it once it's +ve cashflow? i.e. your choice is: do I pay the principle off the loan, or can I use that principle somewhere else? e.g. say you're building a portfolio in Australia, and your principle payments on the UK properties is $10k AUD. Is it better for you to use that $10k to get a 6% return (approx UK interest) or use it to service more IP debt in Australia?

Tax is only one thing to consider.

Personally, the only time when you should go P&I is if you can't save and you would fritter away the extra money if you went IO. Or if you can't use the tax breaks. What you can always do is go P&I UNTIL the UK IPs are fully neutral cashflow (note the difference between +/- GEARING and +/- CASHFLOW) and THEN switch to IO.
Alex

 

[Simone]

You said there is little difference between PI & IO - so it does not sound like the difference would pay for another IP fully in any case?? if you start with PI it does not mean that you cannot change your mind down the track. We have a couple on PI and are glad we did it this way - we like the fact that a couple are being paid off (one is all but paid so we just purchased another due to this reason) and the other one like you have mentioned does not cost a lot more as PI...this is a tough one though, we have wondered in the past as well.

 

[Twitch]

No I don't believe there is just a little difference between IO and P&I.

The difference that matters is the difference in holding cost, not in repayment amount.

I did the numbers and even though the repayments amounts were somewhat close, by the time I translated it to holding cost, the P&I made the holding cost a third to a half more expensive than holding it under IO. That is not a small difference.

Something to consider.....

Good luck

 

[slower_learner]

Twitch,

Just to clarify, do you mean the ongoing costs of an IP, like insurance, management, maintenance, etc? ie the non-finance, non-buying costs.

If so, I included these in my determination of -ve/+ve cashflow. These costs (as I see) will be the same regardless of repayment method. Admittedly I didn't budget for large items like new boilers/kitchens very well, just assumed you extend your mortgage.

If not, could you describe in a bit more detail? I'm not sure I follow you.

Thanks,

slower_learner

 

[slower_learner]

Whether you pay off the P portion or not doesn't affect the future growth of the property

Alexee,

This is the money quote. Thanks. Like a knife through butter.

I'm going away to look at the difference between P&I vs IO and investing in a fund vs IO and more properties. I think this will resolve the matter for me.

Thanks again.

slower_learner

 

[alexlee]

Investment articles often tell you to 'pay off your loan and build up equity'. However, that seems to be the reverse of what investment books tell you to do (don't pay off the loan, instead borrow more to buy more IPs).

'Equity' is market value less loans. So you can 'buy' equity ($1 for $1) by reducing your loans, OR you can increase the market value of your properties. This will be done by value adding or natural appreciation, so the higher your asset base (regardless of your loans) the higher your appreciation will be.

This concept of 'future equity is driven by gross assets and not current equity' is important to understanding why property investors don't worry about having lots of debt.
Alex

 

[Patosan]

The difference that matters is the difference in holding cost, not in repayment amount.

Could you elaborate more on holding costs please ?

 

[Twitch]

Twitch,

Just to clarify, do you mean the ongoing costs of an IP, like insurance, management, maintenance, etc? ie the non-finance, non-buying costs.

If so, I included these in my determination of -ve/+ve cashflow. These costs (as I see) will be the same regardless of repayment method. Admittedly I didn't budget for large items like new boilers/kitchens very well, just assumed you extend your mortgage.

If not, could you describe in a bit more detail? I'm not sure I follow you.

Thanks,

slower_learner

Could you elaborate more on holding costs please ?

By holding cost I mean the bottom line after tax figure that it costs to own a particular IP. Eg, an IP might cost $11,000/yr a.t. to "hold".

When you figure out the bottom line figure to hold a property with IO loans, and then the bottom line figure with P&I loans, the % difference in those 2 holding figures is far greater than the % difference in the loan amounts (particularly for those in higher tax brackets).

Hope that's a bit clearer

 

[Simon]

Of course there is no good or bad.

When you have formulated your goals and strategy to reach them then the answer will be clear.

Too many of us fail to plan. We just add another investment when the time feels right.

I suggest you consider IO and keep all principal in an offset account. This provides the most flexibility. Flexibility to spend the money on personal use if the need arises, to buy another investment or to use it to pay down an IP if you so decide.

Of course the ideal place to keep this principal is in an offset against your home but from what I understand this isn't an option.

Cheers,

 

[kathryn d]

All my mortgages are P&I.
That's a personal choice.
I like the feeling of knowing there is an end to owing on a property.
CG is not really a big factor in my area.