Principal And Interest Or Interest Only?

Discussion in 'Property Finance' started by Jamie M, 7th Apr, 2015.

  1. Jamie M

    Jamie M Mortgage Broker - Oz Wide

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    A question I'm always asked is "should I be paying interest only or principal and interest on my loans" so I thought I'd share my thoughts. For a lot of SS gurus - this info is nothing new but hopefully some of the new members will gain some benefit from it.

    When it comes to claiming an investment loan as a deduction only the interest portion of the loan is tax deductible. The principal portion is not. Therefore, if you have an investment loan, and you decide to pay off some of the principal each repayment, you're effectively reducing this tax deductible debt meaning there is less tax you can claim back.

    This can be a costly mistake for those who also have non-deductible debt (which many of us do). This includes a home loan on your Principle Place of Residency (PPOR), car loans, personal loans, credit cards, etc.

    If you want to pay down any debt it is this non-deductible debt that you should try and knock on the head first.

    So what's the ideal structure?

    Whilst there's no "one size fits all" approach to loan structuring - it's generally a good idea to have all of your investment loans set up as interest only.

    With your PPOR debt, there are two choices to consider. If you are a disciplined saver and feel that your PPOR may one day be turned into an investment property (and you go onto buy another PPOR), then it's best to also set this loan up as interest only.

    However, it's important that an offset account is set up against this loan so you can continue to make the equivalent principal repayments regularly into the offset account. The offset account is also a very handy place for parking any spare savings.

    Why is it best to have my PPOR loan as interest only if I think it's going to become an investment property? Because this debt will become deductible in the future so best not to reduce it now.

    Instead, you can place your money into the offset account which will reduce your PPOR interest repayments whilst the funds are sitting in the account. When this property becomes an investment property in the future, you can move the funds from your offset account on to your next PPOR. This way, you've increased your tax deductible debt and reduced your non tax deductible debt.

    The interest only with an offset account doesn't work very well for someone who isn't a disciplined saver and will be tempted to simply make the minimum interest repayments.

    If you're not a disciplined saver and have no desire to convert your PPOR into an investment property at some point, then it's best to have a principal and interest loan on your PPOR. Once you've paid off your PPOR loan and any other non-deductible debt, you may wish to start paying down your investment loans.

    So in a nutshell, interest only for all loans with an offset account set-up against your PPOR loan can be a great overall structure particularly if you think you might turn your PPOR into an investment property at some point and purchase another PPOR. On the flipside, if you have no desire to turn your PPOR into an investment property down the track and you are not disciplined with money- then it's best to have interest only against all investment loans and principle and interest against your PPOR.

    PLEASE NOTE - this information is of a general nature. Please always consult taxation professionals about the specific nature of your situation.

    Cheers

    Jamie
     
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  2. Redom

    Redom Mortgage Broker

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    Useful post Jamie - thanks! Its definitely a question that i'm usually explaining to first timers when discussing the merits of I/O.

    For investors that are looking to build a portfolio, i'd almost go as far as to say I/O all day long (as long as its an option). Savings patterns/future property use should also be factored into it, but borrowing power is where the juice is really at for investors with I/O set ups.

    On a $400,000 mortgage, by going P&I your increasing your contractual repayment by $500 per month. This means a $6000 hit to your serviceability in the 'expense' column per year. Expanding this out, you're talking a $60,000+ hit to your overall borrowing power by going P&I.

    For 'one time shoppers' and those just looking at a PPOR and perhaps one IP - the above probably isn't relevant at all.

    Cheers,
    Redom
     
  3. bonanzawealth

    bonanzawealth Member

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    Thanks Jamie, That info really shed some light for me
     
  4. almostthere

    almostthere Member

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    Thank you Jamie for this useful post ..and also Redom for supplementing it
     
  5. cimbom

    cimbom Member

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    If you were to have an IO loan for your PPOR but have a direct debit payment set up which was more than the interest payment (so you're effectively paying the principal as well), would this be better for your borrowing power since the contract is still IO?
     
  6. Kinnon Bell

    Kinnon Bell Member

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    Let's not forget that most of the lenders don't take debt at actual repayments. So even if you have an IO loan they calculate affordability/serviceability at P&I payments + a ~2% buffer.

    The lenders who take debt at actual repayments are in the minority.
     
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  7. Jamie M

    Jamie M Mortgage Broker - Oz Wide

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    Hi Cim

    Yep - it would improve your borrowing capacity (with lenders that take the repayments with other lenders at actual repayments rather than an inflated P&I amount) because you'd only have to declare the interest only amount that you're contracted to repay (because technically you could stop the direct debit at any time).

    Cheers

    Jamie
     
  8. Corey Batt

    Corey Batt Finance Broker

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    And that of the ones which do revert it to a P&I calc, they will generally remove the number of years the loan is interest only - significantly decreasing your serviceability.

    ie, a 300k 30 year loan, 5 years IO at 5% = $1,250 per month.

    Some lenders will assess this as (example 2% servicing buffer):

    300k, 25 year loan term, 7% P&I = $2,120 per month.

    Without the IO period, the repayment would be calculated at $1,995 per month
     
    Last edited: 7th Apr, 2015
  9. Jamie M

    Jamie M Mortgage Broker - Oz Wide

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    No worries - glad you found it useful :)

    Cheers

    Jamie
     
  10. oc1

    oc1 Developer

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    Nice to have the complete picture. Thanks Kinnon. :)
     
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  11. albanga

    albanga Member

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    Great post Jamie!

    Another benefit I see in having your cash in an offset is what happens if there is an American style GFC market crash in Australia. If you have a 500k loan paid down in principal to 100k and then values plummet and your property is now valued at 100k then your at 100% LVR. If you want to then go and try and buy up properties, then one you have no deposit and 2 lenders will not be so forthcoming with lending anyone money.

    If however that 400k was instead sitting in an offset then it's your money and you could hypothetically go and buy 4 properties outright (NOTE - I am unsure if lenders have any rules that in a GFC type event that those with large sums in offset must pay down debt?).

    Cash is king
     
  12. Jamie M

    Jamie M Mortgage Broker - Oz Wide

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    Hey Albanga

    No probs - glad you find it useful too.

    That's a good point you make - and something I hadn't really considered.

    Cheers

    Jamie
     
  13. Paul@PFI

    Paul@PFI Tax, SMSF & Planning

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    Definitely agree with the comments by Albanga. Yes banks do tighten credit - Low LVRs and no lend policies for certain properties (ie units in large blocks). Forced reduction ?? Havent seen that except developers where banks treat it like margin calls

    I get asked this question all the time and despite explaining I wont give financial advice on buying a IP I do indicate there are two types of people.

    1. Traditionalists. Once they were called the wogs. Often Greeks, Italian etc. They hate debt. They borrow and try to smash the loan fast and furious. Sure its not tax efficient and deductions dwindle. But for many they build equity fast. They like P&I so they can repay. They use variable rates for that reason. When they have paid off one they buy another. They love to buy when the market collapses.

    2. Modern buyers. Highly geared. No prospect of debt repayment. They focus solely on growth in value to build equity. They seek max borrowings and jump in with both feet relying on growth and stable rates. They like IO. They consider fixed rates as they have zero intent to repay debt and consider the impact of rising rates to their plans. They like income tax variations and maxing deductions. Often exposed to rate rises which haven't happened for a while. Risks are loss of job, tenants and falling prices.

    There is also a third group. These people seek financial indicators in addition to growth. They seek maximising yield. They consider reno's, rebuilds, GF's and other ways to lift yield for less outlay than buying further property (land). They usual favour the loan elements of a modern buyer buy display risk characteristics of traditionalists. Often and usually have greater equity and can consider broader strategies than modern buyers. They love unstable markets and then become modern buyers.
     
  14. Starofdavid

    Starofdavid Banned

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    I'm not the brightest when it comes to financial stuff, but I can't understand why some of you like interest only loans.

    So let me give you an example ok.

    I buy a property in Lithgow or wherever out of the way...
    It's value is 200k
    I borrow 160k and I get tent but pay it all back in interest and pay strata fees and council and stamp duty etc etc.

    2 years later the property is still worth 160k, it means I lost doesn't it ??
     
  15. Ace in the Hole

    Ace in the Hole Don't compete, Dominate !

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    Hey champ, that example is so messed up...

    Look at it this way.
    Everybody has to pay their interest on debt, just like getting taxed.
    However, you have the option of paying extra principle off the loan to reduce it if you want to.
    But, if you pay interest only and take the surplus money you were going to pay the principle loan with, you can invest it elsewhere to create more wealth, far greater than the outstanding debt.
    A 160k loan will still be a 160k loan in 100 years from now, but 160k in 100 years time will be like $2.50 in todays money, so what's the point in paying down extra principle now and making your life harder than it needs to be?
    Debt is good, load up and prosper.
     
  16. Peter_Tersteeg

    Peter_Tersteeg Finance broker/strategist

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    Another way to look at it is to see what happened had you bought a house 30 years ago in 1985...

    Purchased for $50,000 with a loan of $40,000.
    Interest only payments for 30 years, not a cent has been paid off.
    Over 30 years, you'd pay about $96,000 interest (assuming 8% average interest rate)
    Today this property is probably worth $800,000 and generates around $25,000 / year in rental income.

    With this outcome, do you really care that you haven't paid the loan off?

    You could argue that the last 30 years is not an indicator of performance for the next 30 years, but consider that over the first 13 years since 1985, we saw a major market downturn, a major recession and 10 years of almost negligible growth. It wouldn't surprise me if over the next 30 years, history repeats itself.
     
  17. albanga

    albanga Member

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    Great post Paul!
    One thing you forgot to mention though is that whilst the traditionalist pays down debt fast they leverage to the teeth to buy excessive amounts of concrete and cement lions.
     
  18. rroodd

    rroodd Member

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    I look at is like this - the bank ( or 'lender' ) is just a tool to allow me to buy and hold my investment properties. Unfortunately for most of us, this 'tool' is a necessity to achieve what we want to end up with ( ie. a portfolio of a number of properties, held at minimal cost to us. )

    Paying interest only on all my loans is the MINIMAL cost method of using this 'tool' - and as bonus this interest is tax deductable.
     
  19. Spectre

    Spectre Member

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    You run through each but building equity in a PPR which you'll never rent and avoid CGT when you step up or down into the next property has appeal.
     
  20. lizzie

    lizzie when i grow up ...

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    Maybe I'm just a slack saver - but we pay interest only on all our real estate debt - PPOR and IP's

    The stock standard IP's pay for themselves thru rent (interest, strata fees, management fees, acct etc) ... but have increased in value around 50% in the last 6 years ... so happy to let the loan sit as LVRs are now below 60%.

    With PPOR's - we prefer to buy wisely and use funds to increase the value of the PPOR rather than pay off the principal (definitely don't overcapitalise tho).

    This means the mortgage, as a proportion of the value of the PPOR, is significantly decreased and we can either upgrade to another property with smaller LVR - rinse and repeat increase in value with no CGT - and we'll eventually downsize (probably next property) to no mortgage and significant cash in hand.

    Current PPOR has increased in value 40% in 2.5 years so LVR is to down around 18% due to the above "increase value" and upgrade method - so happy to let it sit.

    SMSF IP's cost us less than $180/wk in interest for a six figure income - so we'd rather spend a portion of that income on increasing the income proportionally rather than paying off the mortgage.

    I understand this doesn't work for everyone ... but whilst interest rates are so low we'd prefer to put our spare cash into increasing the values and/or income of our investments - and yes, I see the PPOR as an investment - rather than paying the mortgage off.

    When the time comes that we want to live off the income - then we'll cash out a few investments and pay off the small mortgages.
     
    Last edited: 10th Apr, 2015