Ridiculous Newbie I/O vs P&I question

Hey all - I've been interested in getting into property for years now, but have been travelling the world with the wife for the last few years so it's been at the back of my mind. Now I'm back in Brisbane and settling down with a munchkin on the way, and getting back into it - although probably still 12 month away from buying my first, never too early to start learning, right? So I thought I'd ask a really obvious question that I can't find a ridiculously easy answer to.

I understand the difference between P&I and I/O, and that I/O opens up more cash flow, although you're not paying off the actual principal. Isn't this delaying the inevitable? Very basic googling seems to suggest that the I/O period of most loans are 1 - 5 years, and after that converts to P&I. Is that right?

Basically, I love the idea of using I/O and allowing me to purchase more property with higher cash flow. But at what point would I need to pay back the interest - selling the place after 5 years at a profit isn't really what I had in mind, more of a "buy and hold" guy I think.

Any thoughts would be fab - cheers kids!

-Adam
 
There are no silly questions.

Most people would just roll over the IO term when it expires (onto a fresh IO term). Max IO terms range from 5 to 15 years. A line of credit is IO for ever. Therefore, essentially, you can remain on IO for ever.
 
Hi Adam

Whilst Yes IO will aid your cash flow it gives you flexibility and that is also important.

Normally you would try and set up an interest only loan with 100% offset account. Remember what starts off as your PPOR may end up being a investment property and the last thing you want is to hand paid down the principal only to find that you need to redraw the equity to use as deposit on the next PPOR.

By placing funds in the offset account you preserve the Tax deductability of the loan.

Traditionally IO loans can be upto 15 years or more but more often than not 5years in length. Nothing to stop you rolling over the loan after the expiry of the IO period to another interest only loan with the current lender or if needed going elsewhere.
 
Wow, thanks for the quick answers guys - didn't know there'd be people on here so late! So it basically makes sense that you roll the IO period over - my assumption here is that of course it would "eventually" be paid off, but that rental income (in a perfect CF+ world) would cover the payments and by the time I need/want to pay it off, I can sell the property and the enjoy my millions in capital gain (optimist much?)

In that case, if I can tack another question onto that one - how does an offset account on an IO loan work? If I put all my extra cash into that one, I understand I can keep the interest on my entire IO loan value tax deductable. What are the advantages of an offset account on an IO loan and just a normal bank account? With a P&I loan I understand that redraw sorta thing, where all your money goes into the loan to reduce the debt ASAP - but with an IO loan, the principle doesn't ever actually get reduced anyway. So does it matter where I put my rental incomes/extra cash? Or is it just for accountability's sake?

Thanks again folks! I'll remember everyone when I'm rich!
-Adam
 
Im a newbie too..but i'm going to have a shot.. here's what I understand of it..

(correct me if i'm wrong someone)

On an IO loan, the principal is reduced ..depending on how much you have in your 'offset' account..that's just what its doing..offsetting the total loan

i.e if you have $100k loan, and have $75k in your offset account you are only paying interest on the remaining $25k
 
Ohhhhhhhhhhhhhhhhh. I think you're right - I was reading the top "sticky post" in here by Simon and the story he tells suggests the same thing. In that case, I totally understand now and will almost definitely be doing the I/O + offset etc :)

Hooray for learning!
 
On an IO loan, the principal is reduced ..depending on how much you have in your 'offset' account..that's just what its doing..offsetting the total loan

i.e if you have $100k loan, and have $75k in your offset account you are only paying interest on the remaining $25k

The principal stays the same. You have two accounts. A loan of $100k and an offset of $75k. You are, however, correct that you only pay interest on the $25k.

By having it set up in this way, you are preserving the loan balance (presuming it's your PPOR), should you wish to move elsewhere and turn your PPOR into an IP.

It is also an effective way of tax-free saving. Why put funds into another account (and get taxed on the earnings), when you can put the funds towards your borrowings and have the flexibilty of drawing them out whenever you want to.
 
In a savings account, you'd get taxed on the interest - but in an offset account, you're reducing the amount of interest that you have to pay on the original I/O balance, and you claim that interest as a deduction anyway. That sound about right?

I'm learning a heap off these forums - good stuff. I'm sure there's other newbies that have read this and said to themselves "Man, I'm glad that guy asked it!"

Thanks again everyone!
-Adam
 
Adam

Almost there. In an offset account you dont actually receive any interest so have nothing to declare.

The interest you would have been paid is deducted from the interest you are charged on the corresponding linked home loan.
 
Hi Richard - that's actually what I meant, just didn't word it properly :p Stupid English.

So what's the difference then, if any, between an offset account and a redraw account?
 
An offset account is a totally separate savings account which is linked to appropriate mortgage account whilst a redraw account is normally a feature of the loan where extra payments are paid directly into the loan and can then be withdrawn.
 
When you deposit funds into your loan you are in effect paying down your loan. Then each time you redraw you are in effect making a new loan.

If you redraw for private use then it isn't deductible.

An offset account is a different account so it wont cause tax complications.

I cannot think of a situation where redraw is more efficient than an offset account.
 
what if money is sitting in your PPOR loan available as redraw ....... you set up an offset account and move the money over there and have it there for several years before using it as a deposit and costs to purchase a new PPOR and turning the original PPOR into an IP???

Does this effect the deductability of the now IP loan???
 
it sure does, because when you redraw it from the loan, you arent redrawing it for investment purposes, you're redrawing it to put in an offset against your (current) PPOR.

this is exactly the reason its recommended to go IO with 100% offset for a PPOR that there is even the slightest chance you might change to an IP later on - if you have it setup this way, you simply buy your new PPOR, and put the money in the offset against it (reducing non-deductible repayments) and your previous PPOR, now IP loan, shoots back up to its full amount, getting you as much deduction as possible.

if you had done the normal P&I and payed off some of the principal, when you do the switch you can never 'increase' the loan back to the full amount and retain full deductibility of that amount, because any redraw on what would now be the IP, must be for investment purposes to retain full tax deductibility.

so, if you are 101% sure you will never ever want to change your PPOR to IP, then you can go with a normal P&I and pay it off and redraw to hearts content, but you never want to do this if you will eventually want to make it an IP in future.
 
its good people are thinking about this and making sure they do the right thing from the start, as so many people dont realise this and it is only no end of trouble later on (currently the first 2 threads in this forum are both about people who have P&I PPOR they have paid a lot off and now want to make it an IP)
 
this is exactly the reason its recommended to go IO with 100% offset for a PPOR that there is even the slightest chance you might change to an IP later on


Thanks everyone for the forum.
I bought my first PPOR 12 months ago, and my "then" mortgage broker didn't give me this advice. So i'm in the situation of seeing if it is worth refinancing so that I can now be set up properly.
 
Hi Little Buddy

Depending on the original lvr it may not be worth looking to refinance due to the potential lmi costs which maybe incurred again.

If your current lender offers a 100% offset account with an interest only loan you maybe best to merely stay put and switch the type of loan.

For future IO with 100% offset gives you flexibility as you never know when you might need this.
 
Top