Help me work it out - Better PI or IO?

I have been working on a spreadsheet in an attempt to find out when it would be more beneficial to take out a PI loan on an investment instead of an IO loan - while still having non-deductible debt.

It is not easy and I can't get my head around it.

Attached is my draft spreadsheet.

In the example I have used the following figures
$500,000 loan
PI investment loan of 5% p.a.
IO investment loan of 5.6% pa
Tax Rate of 39%

Paying PI would result in an after tax cash flow of $22,525 pa
While paying IO would result in an after tax cash flow of $17,080

That difference is $5,444 per year.

This is an extra $5,444 per year that could be paid off the non-deductible main residence debt.
And this is even when the rate difference is 0.60%

Even when I make the gap wider IO still seems to come out ahead.

Anyway I am not sure on how to work out at what point of interest difference it would be better to go PI.

 

If you are just trying to find what rates give equal P&I and IO repayments, then you can just use the mortgage repayment formula:

and solve for M=Ps (IO interest repayment) for a given IO interest rate s, P&I interest rate r, and home loan term n. Note that P cancels out immediately; the loan amount doesn't have a bearing.

Since I don't want to do the actual maths, I used Excel and for a 30-year loan with monthly repayments, the repayments are equal when the IO interest rate is 1.28837 times the P&I interest rate.

e.g. P&I 5.00% = IO 6.44%

Actually hold that thought, just realised it changes based on P&I rate. Correction incoming

 

So turns out the equation is much more complex than just linear... which would have been obvious if I even started to think about the equation

 

No, I want more than that!
I worked this out in the thread at:
Loan Tip: At What Point does IO = PI? https://www.propertychat.com.au/community/threads/loan-tip-at-what-point-does-io-pi.22554/

I also want to factor in the tax savings.

 

Like my post #2 above, you only worked it out for one P&I rate. The graph shows that the basis point difference ranges from 53 to 286 for P&I rates 1-10%.

Will be interesting to see if the graph changes once tax savings are accounted for...

 

It would also change depending on the premium between IO & PI and also vary depending upon your tax rates.

To complicate matters further if there's proportional ownership eg 50/50 or 99/1 or 75/25 and each party subject to different tax rates/treatment (non-working spouse, company, trust, minor, non-resident, charity etc) then the comparison would be further complicated. Which is one reason all calculations should be done exclusive of tax.

 

Is it possible that IO cashflows only comes out ahead in the first 5 years of IO, then the cumulative PI cash flows beyond year 5 make IO more expensive? See first photo.
Interest rate on IO would have to be LOWER in order to make it more worthwhile over a 30 year loan? See 2nd photo.

I maybe looking at this wrong though. Cannot send files sorry.

 

Redid the graph assuming a tax deduction on interest at the 3 top marginal rates. For P&I, I took the average interest per payment over the life of the loan; the deductions will be higher early on.

 

Pretty tricky stuff! I think it all depends on the amount of non-deductible debt loan and it's rate too?

(nonDeductibleLoanValue-cashFlowDifference)*(rateDifference)/100 = Interest savings on non-deductible debt.
for example:
0.5 rate difference and non-deductible debt of 500000: (500000-5444)*0.5/100=2472.78
1.0 rate difference and non-deductible debt of 500000: (500000-5444)*1/100=4945.56

0.5 rate difference and non-deductible debt of 500000: (300000-5444)*0.5/100=1472.78
1 rate difference and non-deductible debt of 500000: (300000-5444)*0.5/100=2945.56

So the bigger the non deductible debt and the higher the rate difference , the bigger the savings.

 

I've been trying to figure out a comprehensive solution to this for a couple of months now. With a rate difference of about 1.5% it's fairly easy to be convinced that P&I is the better solutions.

For some people, even just a 0.5% difference is sufficient to make P&I the better choice, but there's also a lot of 'soft' things that may need to be considered.
* Does today's cash flow take priority over higher repayments in 5 years time?
* Would it be feasible as part of the long term strategy to sell in 5 years?
* How long has an existing loan already been interest only?
* What exit strategy options does the borrower have from I/O to P&I today and when the I/O period expires? Serviceability plays a big part in this.

Quite a few lenders are offering fixed P&I loans below 4% at the moment. This may be a better solution for many people than a variable interest only loan. Whilst today the cash flow on the I/O loan may still be cheaper, we're probably going to see further increases in the future that may mean that fixing with P&I today might be very cost effective.

This doesn't solve the problem outright and I don't think there is a definitive solution without having a crystal ball. It does heavily mitigate the problem for a few years though.

 

Ultimately I now think the deciding factor just needs to be cashflow.
If cashflow is not an issue then pay down investment debt at P&I.

In the long run I think almost everyone will win by doing this! Even if you discover that the difference is at .60 or whatever it is, if someone has the capacity NOW I would advocate P&I.

The old days of max leverage are gone and I think in the end it will only benefit people when they may have less property but own more of it. I know which I would rather.

 

Its not just about cash flow because even if you have plenty of cash flow it might be worthwhile paying a higher rate on PI loans so you can devote more of that cash flow to the paying down of non-deductible debt.

At what interest rate difference this advantage diminishes I am not sure, but even at 1% it still seems preferrable to to go IO on investments.

 

The fact that it's hard to work out because of a myriad of soft factors (which are themselves in constant flux) suggests hedging and doing a bit of both is not a bad strategy

 

IO allows you to be more flexible in whether or not you want to pay down more or not but at least allows you to store additional cash into your non-deductible offset account to take advantage of any opportunities that presents itself. This is as long as repayments for IO is less than PI. For someone like me in accumulation phase I don't see much advantage in paying down debt via P&I and risk paper losses if value goes down. If value goes up, thats a bonus for me.

Please feel free to rip apart my thinking as I'm still early in my journey but I hope I'm on the right track!

 

I think it is complex to model because the answer depends on the amount of non-deductible debt, the interest rate on that debt, the tax bracket of the investor etc. It's even more complex when it is partners on different tax rates.

Could you start off with a single person with no non-deductible debt, work that out then refine the model from there?

The other factor I was thinking is missing is time. The answer over 1 year will be different to 5 yrs, 10 yrs, 15 yrs etc. From another thread:

 

Absolute difference aside going PI does create a forced / disciplined savings plan which has its merit which is hard to measure.
Also what if you have paid off your PPOR how does that change your modelling?

 

It would be a large effect because one of the main reasons to go IO is to divert extra funds to the owner occupied debt.

 

I really just believe IO is an old way of thinking (for now anyway). The only benefit I can personally see is cashflow and even that is getting tested. Many commentators are expecting the gap to widen to 1% and at that point I think it would be ludicrous to do anything but P&I.

I know we can cut it ten different ways to show arguments that paying IO when factoring in tax is still beneficial but that relies solely on a 100% disciplined strategy of putting every extra repayment into non deductible debt.

Theory = Great!
Practice = Highly Unlikely!

Most people simply do not have that level of discipline.
IO use to have far greater benefits and was a no brainer, you could make some slip ups and still be better off. Now the cash benefits are being minimized meaning employing this kind of strategy has no room for error.

My new way of thinking is so long as you have the capacity is ensure you have a buffer! If that means IO for a year or so to put into your offset then do that. Then if cashflow allows it pay down all debt at P&I.

This is coming from someone who advocated IO whole heartedly.

 

Just playing with my calculator again, at a 1% difference on a $500k loan
PI interest in year 1 would be $24,832 (at 5%)
IO interest in year 1 would be $30,000 (at 6%)
That is $5,167 extra interest to pay IO

But cash flow is different because the interest is deductible and because Principal component is about $7,377

After tax cost ends up being, from a cash flow pov:
$4,244 less for the IO loan.

That means paying 1% more on a IO loan could lead to an extra $4244 being paid off the main residence debt.

But doing this comes at a cost because an extra $5,167 in interest would be incurred on the loan.

 

So two tuppences worse off in a round-a-boutish way?

Have you taken into account that if it were PI, then the balance on the deductible loan would also decrease