Interest rates are a hot topic right now. Up until recent times, home loan rates were identical to investment loan rates. Over the last few months, banks have been slowly increasing interest rates to the point where Interest Only (IO) loans are 1% higher than Principal & Interest (P&I) loans. With a 100 basis points’ price difference, one must consider whether it still makes financial sense to pay IO on your investment loan.
Quick recap on why this is happening…
APRA (the regulator) wants mortgage customers to start paying down debt and therefore they have directed banks and lenders to significantly reduce the volume of existing and new IO loans. Refer to my prior blog explaining APRA’s guidelines and direction to banks and why IO loans are now more expensive than P&I loans.
Should I pay off my home loan before making principal repayments on my investment loan?
In many cases, the best strategy is/has been to pay off your home loan debt first, before making principal repayments on your investment loans. This strategy enables you to optimise your tax benefits by directing more cash towards your non tax-deductible debt before paying down your investment (tax-deductible) debt.
In some cases, it also makes sense to pay IO on your home loan whilst accumulating cash in an offset account (or redraw). This strategy enables you to tap into the growing equity of your property and leveraging it into more investment assets (like property) to create wealth faster. “Time” in the market is the key to creating massive wealth through property. Making IO repayments buys you time and enables you to buy more property sooner.
Whilst the above strategy is still valid and still appropriate, the higher interest rate for IO loans has raised the question on whether IO repayments still makes financial sense.
Your situation is unique to you, and unfortunately there is no simple rule of thumb. However let’s look at a scenario to help you decide if paying IO on your investment loan is still the right strategy, or whether you should switch to P&I repayments.
- Mr Client has a $500k owner-occupier (OO) home loan, and
- Mr Client has a $500k investment (INV) loan
- For the investment loan, let’s assume the P&I rate is 4%, and the IO rate is 5%
What the numbers are saying if making P&I repayments on the investment loan
- Repayments $2,387 per calender month (pcm)
- End of Year 1, cash flow required $28,644 ($19,840 interest + $8,804 principal)
- Balance owing $491,195
- End of Year 5, cash flow required $143,220 ($95,458 interest + $47,762 principal)
- Balance owing $452,238
What the numbers are saying if making IO repayments on the investment loan
- Repayments $2,083 pcm
- End of Year 1, cash flow required $25,000 ($25,000 interest + $0 principal)
- Balance owing $500,000
- End of Year 5, cash flow required $125,000 ($125,000 interest + $0 principal)
- Balance owing $500,000
Go to the calculators page on our website to work out other scenarios.
Which is better? IO repayments or P&I repayments on the investment loan?
Let’s look at the pros and cons using the above scenario to help you decide.
Advantages of paying IO…
- Less cash flow required, $18,220 over 5 years ($3,644 per annum, or $304 pcm)
- The extra $18,220 cash over 5 years could reduce your OO loan by around 6 years
- Paying OO debt quicker means more equity in your PPOR, which can then be leveraged/geared into buying more investments and creating more wealth
- Interest on investment loans is tax deductible, whereas on your home loan it isn’t
- You take advantage of negative gearing benefits, therefore the extra interest paid is shared between you and the ATO (e.g. the ATO would foot the bill by as much as $23,171 based on the average marginal tax rate of 30%)
Disadvantages of paying IO…
- Greater scrutiny by banks and lenders when assessing IO loans
- At the end of 5 years, loan owing is still $500,000
- At the end of 5 years, interest paid is $77,238 higher
- Making P&I repayments from Day 1 on your investment loan will result in paying off the loan around 6 years sooner, saving $150,000 in interest
- Whilst IO loan would result in $304 pcm in extra cash flow (which can be used to pay off your OO debt sooner), usually the cash would get lost in a “black hole” resulting in nil overall benefit of making IO repayments
Deciding on which strategy is best for you all comes down to your future plans and your personal situation. Issues you should consider are:
- Your age
- Your wealth creation strategy (e.g. aggressive or passive)
- Your appetite for risk
- Your available cash flow
- What you can afford in terms of repayments
- The size of your financial buffers
- Your investment timeline
Ask yourself, do you have sufficient equity built up in your property (or properties) that you can release to beat the banks at their own game? Can you use the equity release to help supplement your cash flow and make P&I repayments, therefore paying less interest? Food for thought perhaps..!!
In closing I’ll say this. IO loans have their place for a sound wealth creation strategy, however there comes a point when you have to ask the question whether it’s still sensible to pay more interest to the bank, or whether that extra interest is best paid off your own loan.
When deciding, bear in mind that some banks and lenders are now reluctant to refinance IO loans and therefore you may be “stuck” with your current lender once the loan reverts to P&I. This means that your loan will be amortised over 25 years on a P&I basis at the end of the 5 years’ IO term. If this occurs, your cash flow will be significantly impacted.
Plenty to think about, but this is the reality we’re faced with. If you feel stuck and want the right guidance and advice, feel free to contact us.
Disclaimer: This information does not take into account your individual objectives, financial situation and needs. You should assess whether the information is appropriate for you and seek specialist advice from a qualified and licensed advisor.