P&I investment loan repayments vs negative gearing using interest only payments is a bit of a topic currently with our client base. As interest rates on the I/O loans higher than P&I loans. So from a wealth creation stand point there are now additional benefits to going P&I on your investment loans. As the cheaper rate means you can pay off some debt effectively for free. Now for the negative gearing types out there they will want maximize the interest payable, especially if they have non deductible debt.
But it all boils down to your risk profile and strategy. But I still feel that you shouldn’t buy an investment property for the tax deduction. The investment has to stack up. So with this in mind I want you to look or at consider P&I as a viable alternative.
We are in a low interest rate and low growth environment with political factors around negative gearing. Which swings the argument towards P&I repayments for a variety of reasons. Cash flow is probably the most critical factor you will need to consider. At Mortgage Advice we are not allowed to make this decision for you, but we can advise of the pros and cons of each strategy. Let me know if you want to discuss in more depth.
Reasons you should consider P&I on your Investment property:
1) As per above, the rate is lower. The gap with most lenders is around 0.25%, so on $400k loan is $1000pa. This saving can be used to mitigate some of the additional cash flow cost of the P&I loan. This amount compounded over the life of a loan is significant. Even if you discounted back the tax deduction on difference between the total interest for the year of each loan. I have some math below.
2) Your overall borrowing capacity will be higher. As banks assess all loans on the remaining P&I term repayment. Not the current I/O repayment as they are required to look at the highest repayment of that loan as they can’t assume you will be able to roll into a new I/O period.
3) In a low growth environment paying down debt means you will be improving your loan to value ratio. In the first few years of the loan interest will be the significant part of the payment. So there will still be interest to claim against.
4) The total cost of the interest on the loan is lower.
Reasons not to:
1) cash flow – as the P&I repayment is higher there will be a higher cash flow drain to begin with. Though the tables are turned when the loan comes out of interest only. But there is an argument for renewing every 5 years of taxation purposes. Though this is no longer a certainty under current lending interpretations of responsible lending. Especially if you are getting closer to retirement.
2) You could use a debt swapping strategy with your owner occupied property. In which case you are moving the principle to the Owner occupied (non deductible debt) anyways
The Math below:
Before we start I have used some minor rounding in the math to get whole numbers. So this is not quite 100% accurate, though it is very close. As your scenario is likely to differ think of this as a reference point only.
$400k loan over 30 years P&I at 3.6%pa repayment $1818/mth and total interest on loan of $255,000 .
$400k loan over 30 years 5 years interest only at 3.85% repayment $1283/mth interest cost for the 5 years is $76,000.
remaining 25 years P&I at 3.6% is $2024/mth and total interest on loan of $207,000 + $76,000 = $283,000
So as you can see the difference adds up over time, about the tune of $28000. but lets put that aside for now.
Year one interest comparison.
Interest on P&I loan is approx $14,280 at 3.6% (Principle is approx $7536) total repayment for the year $21,816
Interest on I/O loan is $15,396 at 3.85%
interest difference over the year is $1,116. So when it comes to the negative gearing calc (lets use a 40% tax bracket) the tax advantage lost is about $446 for the year. The interest saving and the P&I repayment is in front from a wealth creation standpoint to about $670. If you are on a lower tax bracket this would difference would be greater.
total repayment for the year $21,816 less i/o repayment of $15396 is $6420.
Another way to look at this is you have spent $6420 to get $7536 (less applicable tax adjustment) . Its not a bad return on investment as a percentage. Which at the end of the day what investing is about.