Interest-only loans (IO) vs principal and interest (P&I) loans
The conventional wisdom is that it’s better to pay interest-only on an investment property as it gives you better flexibility and cash flow.
However, in many cases, making principal and interest repayments can be a good thing for investors.
You should consider your borrowing power, your intention to buy more properties or not, and what your priorities are (paying less interest vs buying more properties) when deciding between principal and interest versus interest-only loans as an investor.
Key idea: IO vs P&I for property investors
The central idea is to use cheap lenders with conservative borrowing power and P&I loans to buy as many properties as they allow.
Then when you run out of borrowing power, switch your loans to interest only and take out loans for new properties with lenders that allow you to borrow more but usually charge a slightly higher rate.
Now before we dive in, let’s briefly touch on the main difference between an interest-only loan and a principal and interest loan.
Interest-only loans (IO):
- You only repay the interest on your loan.
- Your principal (original loan balance) stays the same.
- Interest-only repayment is set for a specific period of time, usually five years. Although, with a few lenders, the IO only period can go up to 10 to 15 years.
- When the IO period ends, you can either extend the IO only loan term or refinance to extend the IO only period.
Principal and interest (P&I) loans:
- You make repayments on both the interest and a portion of the principal.
- Since your repayments exceed the interest charge, you’re paying off a small portion of the loan with each repayment thereby reducing the loan balance.
- The principal portion is not tax-deductible for investors; only the interest portion is.
Interest-only vs P&I: The interest rate factor
Interest-only (IO) loans often have a higher interest rate. Investment loans also have a higher rate in most cases. An interest-only investment loan has a higher rate still.
On average, IO investment loan rates were higher by 0.31% compared to P&I investment loans based on the advertised rates of the Big Four banks as of June 2020.
Case study: The difference in interest paid
Let’s look at how the two types of loan affect John’s repayments.
John is looking for a $500,000 loan and is deciding between an interest-only vs principal and interest on an investment property.
| Investment loan | Principal and interest | Interest-only (for 5 years) |
|---|---|---|
| Interest rate | 4.09% p.a. | 4.34% p.a. |
| Loan term | 30 years | 30 years (5-years IO) |
| Monthly repayments during IO period (5 years) | Not Applicable | $1,808 p.m. |
| Total interest payable | $368,713 | $407,728 |
| Additional interest payable | $0 | $39,015 |
*Based on the assumption that the variable rate converts to 4.09% once IO term expires.
In general, IO offers you a better cash flow during the interest-only period because you’re only paying the interest charges; however, this also means that over the lifespan of a loan, you end up paying more interest.
In John’s case, he’ll pay $39,015 in extra interest due to the IO period.
On the other hand, he will have an additional cash flow of $7,257.08 per year for a total of $36,235 in five years due to the IO period.
John can use this additional cash flow to acquire more properties, or if his goal is to pay less interest, he’ll be better off with a P&I loan.
You can use our IO vs P&I calculator, which will give you a detailed breakdown of your cash flow, interest expense and tax deductions over the life of your mortgage.
Interest-only vs P&I: The borrowing power factor
For interest-only loans, most lenders are buffering the repayments on the residual P&I loan term.
That is to say if you were on a 30-year loan with a 5-year interest-only period, your borrowing power is calculated as if you were on a 25-year loan. This significantly reduces your borrowing power.
If you have existing loans on interest-only, some lenders use the above method while others use the actual repayments plus a small buffer. This small difference in methodology can mean a big difference in your borrowing power, especially for investors with multiple properties.
So, if you want to maximise your borrowing power then with some lenders paying P&I gives you a higher borrowing power whereas with others this is not the case.
Case study: Borrowing power on actual repayments vs assessment rate
Let’s say, John wants to buy an investment property. He’s earning an annual gross income of $90,000 (before tax). For our borrower power calculation, he is single (no dependents) and has no liabilities.
For a 30-year term home loan with a 5-year interest-only period, using a lender who uses a floor assessment rate (5.40% p.a. in this case), his maximum borrowing power will be $599,707.
Now if we’re using a lender that uses actual repayments, for the same loan, John can borrow up to $704,000 (assessed at his actual repayments at an interest rate of 4.34% p.a.).
That’s a difference in borrowing power of $104,293. For simplicity, no negative gearing benefits have been factored into this calculation.
P&I vs IO: Optimising tax deductions
With investment properties, one of the expenses you can claim the tax deduction on is the interest paid on loans.
With an interest-only loan, all the payments made during the IO period are tax-deductible. Whereas with a P&I loan, only the interest portion is tax-deductible, the principal portion is not.
E.g. If you’re making P&I repayments on a $500,000 loan, in the first year, you would have paid $16,849 in interest and $9,760 in principal, where only the interest portion will be tax-deductible.
Case study: Amortisation schedule P&I loan
Calculations are based on a $500,000 P&I loan at an interest rate of 4.09% p.a.
| Year | Interest paid | Principal paid |
|---|---|---|
| 1 | $16,848.84 | $9,760.08 |
| 2 | $16,511.77 | $10,097.15 |
| 3 | $16,163.06 | $10,445.86. |
| 4 | $15,802.34 | $10,806.58 |
| 5 | $15,429.11 | $11,179.81 |
| Total | $80,755.12 | $52,289.48 |
By the end of year 5, you would have paid $52,289 off the principal the entirety of which is non-tax deductible.
In conclusion, your choice depends on your goals (buy more properties or pay less interest), and your situation (borrowing power).
Tips for property investors
- A multi-lender mortgage strategy is often a good approach. Again, the idea is to use cheap lenders with conservative borrowing power and P&I loans to buy as many properties as they allow. Then when you run out of borrowing power, switch your loans to interest only and take out loans for new properties with lenders that allow you to borrow more but usually charge a slightly higher rate.
- Pay off your most expensive debts first. In most cases, these are credit cards and personal loans; however, few property investors have these. Then your home loan is usually more expensive, even if it has a lower interest rate because it is not tax-deductible.
- Draft an exit strategy. Investors opting for an IO loan need to consider what their exit strategy will be once the IO term expires. Investors will need a new budgeting plan for when that happens. Since the majority of lenders nowadays require a new assessment for IO extensions, speak to one of our mortgage brokers to formulate a financially viable plan.
- When comparing interest rates, consider that nowadays, fixed-rate loans are definitely cheaper than variable even for investment loans. This may or may not be the case all the time, so consider both fixed and variable rates.
- If you plan to turn your home into an investment property, later on, it is a good idea from a tax savings perspective to put extra repayments into the offset account instead of paying off the home loan balance.
Still unsure which is the right fit for you?
Ultimately, both principal and interest vs interest-only loans can be suitable based on your individual situation and goals.
Speaking to a mortgage broker can help to clarify which option is best for you.
Talk to one of our award-winning specialist mortgage brokers by giving us a call on 1300 889 743 or by filling in our online assessment form.