Help me work it out - Better PI or IO?

This has inspired me to start from scratch and approach the whole P&I vs IO topic from a wholistic point of view. Basically by asking the simple question "which option leaves me better off?"

Therefore I looked at the full scenario:

• the IP loan is paid off after the term of the loan (30 years)
• IO reverts to P&I after x years
• we pay a certain amount of interest, and make a certain amount of deductions
• we invest spare cash each month in an offset account against the PPOR loan

With a short-term focus, it is easy to favour IO as the monthly repayments are lower and the deductions stay constant since the monthly interest doesn't change during IO. Compared to P&I we have more cash to put in the PPOR offset. However once IO reverts, the repayments become higher... so the question then becomes: was it worth it? Do we now have enough in our PPOR offset to compensate for the new higher monthly repayment?


(except for the IO period, the curves go upward because the amount of interest and therefore deductions goes down over time)

I am going to use the CBA rates to keep these results relatively grounded:
PPOR P&I=3.85% IO=4.07%
IP P&I=4.03% IO=???

We calculate how much we have accumulated in the PPOR offset (extra that we saved vs the competing method after deductions, compounding each month thereafter), then subtract the total repayments over the 30 years, to arrive at a net standing. For the given IP P&I rate of 4.03%, we then goal seek the net standings to be the same to arrive at an "equivalent" IO rate based on 3 variables:

• IO term = 5,10,15 years
• PPOR rate = P&I(3.85%), IO(4.07%)
• Marginal tax rate(MTR) = 32.5%, 37%, 45%

Scenario 1: IO 10 years, PPOR 4.07%, MTR 37%
Result: IP IO rate = 4.067% = 3.7bp higher than P&I
Comment: the intended goal of IO i.e. make the most of the money you save at the start

Scenario 2a: IO 10 years, PPOR 3.85%, MTR 37%
Result: IP IO rate = 4.025% = 0.5bp lower than P&I
Comment: when the PPOR rate is lower, IO has less benefit at the start, and loses out to P&I

Scenario 2b: IO 10 years, PPOR 4.07%, MTR 45%
Result: IP IO rate = 4.158% = 12.8bp higher than P&I
Comment: higher tax bracket = more deductions = easier for IO to get ahead

What is interesting about the first variable (IO term) is that there seems to be an interplay with the marginal tax rate. Unlike the other 2 variables, there is no simple rule to follow. For lower income earners, less IO is better; for high income earners, a longer IO term is better.



However the discovery from scenario 2b still holds true: the higher the marginal rate, the larger the benefit of IO. So if we change all 3 variables to be most in favour of IO:

Scenario 3: IO 15 years, PPOR 4.07%, MTR 45%
Result: IP IO rate = 4.185% = 15.5bp higher than P&I
Conclusion: the actual CBA IP IO rate is 4.44%. I think P&I comprehensively wins.

 

Now to add a twist. APRA may change its rules so might the Banks adding another layer of risk. Who would've guessed that APRA would change the game so much over the past year? Or the new bank tax from the budget?

 

Thinking beyond my findings in post #21... what if, rather than just putting spare cash in a PPOR offset, you:

• Pay down the PPOR loan and redraw a new split for investments (a.k.a. debt recycle), or
• Invest directly, because you have no non-deductible debt

Assuming an IP IO rate of 4.44%, one can then determine the net return required of those investments based on one's marginal tax rate and IO term length:



In both investment situations, the above returns are required as a net result i.e. after income tax on dividends/distributions, capital gains tax on growth, management/brokerage fees etc. In the case of debt recycling, the tax-deducted investment loan split interest must also be taken into account.

 

I am relatively new to the game (joined SS just before PC was born) but my impression was that in the days before APRAhensive, one could keep extending IO indefinitely so one only needed to look at the short term... thus "IO with offset" became the default recommendation.

Now that IO terms have a more and more finite lifespan (seemingly every month!?) it is only really an acceptable solution if you are sure you are going to make maximum use of money saved early on.

My debt-recycling portfolio is doing well, but not well enough given me+my wife's combined marginal tax rate and likely IO term lengths. Will sit on this thought for a short while before filling out some switch forms

 

Interesting analysis Chylld (i just realised, is your name a play on the word :chilled") but I didn't understand anything you wrote in the last 2 posts.

 

I'm sure by tomorrow morning, I won't understand it either So while I'm still awake...

I'm looking at the total cost of a loan, and the amount saved in the PPOR offset, to arrive at a net standing for:

• each IP loan type (P&I, IO)
• IO term of 5, 10 or 15 years
• different PPOR loan rates
• different marginal tax rates (which affect deductions on the IP loan interest)

By tweaking each of these variables one at a time, and using the CBA rates as a starting point, I found the combination that gives IO the best argument against P&I... and the crossover point had the IO rate 15.5bp higher than the P&I rate.

I concluded that P&I wins since CBA IP IO rates are actually 41bp higher than P&I rates.

edit: reworded

 

This is really doing my head in lol I had a go at it again but still can't make much of the direct results.

INV loan (25 years)-IO @5.6% yearly scenario
500k (5.6%) -> 28000k IO or 37639 PI -> 28000-37639= 9639 extra money that can go on non deductible debt if we use IO at this rate and INV debt stays the same so more tax deductibility

PPOR loan (25 years)
500k(4%) - > 32006
-9639K (4%) -> 617$
617$ extra savings on non deductible loan
9639*5.6/100 = 540$ more tax deductibility on INV loan (Principal portion of INV loan)

INV loan (25 years)- PI @ 5% yearly scenario
500k (5%) - > 35476k PI -> 28000-35476= 7476K less money that can go off non deductible debt so we pay interest on an extra 7476K and we get -10310K in INV debt (paying it down after a year)

PPOR loan (25 years)
500k(4%) - > 32006
7476K (4%) -> 479$
479$ a year more interest on non deductible loan
10310*5/100 = -515$ lost tax deductibility on I INV loan (Principal portion of INV loan)

I think there is one major missing link which is the timing in the life of the loan because the value of money varies during the lifetime of a loan. What i mean by that is that If you just bought the PPOR and you are adding 9639K cashflow to that PPOR loan from the INV loan, that 9639K will have a massive effect in the first few years since the rate of return on that money is to the rate of 300%-400% as per below thread :

How do I get there?

 

Yes I see that as the advantage of IO... you have more money to play with in the first few years and after you put it to work in the PPOR offset, it effectively compounds over the life of the loan.

However when IO reverts to P&I, your repayments jump up to a level higher than if you started off with P&I, and consequently less goes towards the PPOR offset.

For your scenario of 25 years, 4% ppor, 5% ip P&I, 5% ip IO, and assuming 10 years IO and 37% marginal tax rate, the monthly repayments start off at $2922.95 for P&I and $2333.33 for IO. After tax deductions on interest, P&I is out of pocket $2152.12 vs only $1470.00 for IO, so in the first month the IO option puts an extra $682.12 into your ppor offset.

If we only look at the difference between offset deposits between p&i and io, after 25 years you end up with:

P&I: $737,437.59 in loan repayments, $246,816.73 in the offset (including compounding at 4% as a dollar put in at the start has more effect than a dollar put in at the end) for a net standing of -$490,620.85

IO: $827,700.60 in loan repayments, $205,545.45 in the offset, for a net standing of -$622,155.14 ... or $131,534.29 worse off than doing P&I from the start.

Seems counter-intuitive until you look at the out of pocket curves (repayment minus deductions)



At year 10 (120 months) when IO reverts to P&I, suddenly you are out of pocket $895.55 more that month than if you had started with P&I.

 

Thanks for that @chylld ! Great stuff
How does that curve look like in a three year and five year I scenario please? Also shouldn't the IO loan rate be higher than PI to test our scenario?

 

What about refinancing it on IO with either the same provider or a different one after 5 years for argument sake? I know it's getting harder, but assuming that interest rates increases means that APRA will loosen its restrictions, how will the graph look after? Or even doing IO for 5 years + another 5 years before refinancing to a P+I for 30 years, doesn't that work better?

 

I typo'd... the graph was for IP IO rate = 5.6%.

Here's 3 vs 5 vs 10 years IO:

 

If you could extend IO at will, and then refi to a new 25-30 year P&I term, then I think that would be the best case. You would enjoy the low flat portion of the IO curve and then when you decide to pay down the principal (e.g. to free up serviceability or create more positive RE cashflow) then you join the P&I curve at it's starting point.

However as @Peter_Tersteeg pointed out earlier, banks will take into consideration how long the loan has already been under IO, so they may a) not let you extend IO further, and (in theory) b) not let you get away with such a long P&I term. Though I guess you could circumvent b) by spousal transfer etc and putting a new name on the title...

 

Nice work guys, I have been waiting for this thread to happen and thinking a lot about it too, so thank you.

Chylld, just one question, which I apologise for in advance if stupid! In your calculations, after the IO period the repayments revert to P&I and obviously more P to pay which all makes sense. However, the interest rate you've used is the IO interest rate even after the IO period. Why wouldn't the loan revert to the P&I interest rate after the IO period is over?

 

Ahh that makes sense, doesn't it? Remodelling now.

 

For the scenario of 25 years, 4% ppor, 5% ip P&I, 5.6% ip IO (reverting to 5%), and assuming 10 years IO and 37% marginal tax rate, the corrected benefit of P&I is now "only" $90,186.00.

The graph largely looks the same, but the IO curve is slightly lower after it reverts to P&I (with the P&I rate... thanks @LIDM!)


Crucially, these are the rates at which IO becomes preferred over P&I 5%. They are all short of the 5% P&I rate, let alone 5.6%... (for various IO terms and tax brackets)


When would IO 5.6% be worth it? When you can invest/debt recycle at these net returns (rather than just offsetting a 4% PPOR loan)

 

Thanks for working this out Chylld.

 

Thx again @chylld

 

Welcome... took me a while to get there but I hope it answered some questions.

Also my new way of thinking... every tool has a time and place, and for me P&I gives me what IO no longer can. Just switched >$1m of loans to P&I. IO is still handy for PPOR (as it has an offset) as well as equity release splits that haven't been used up yet.

Future equity releases will tap into the principal I pay off until then. One downside of P&I is that the splits won't have nice round balances anymore, however CBA decided to stuff mine up ahead of time by paying 33 cents off the loan limit of several of my splits anyway, so might as well finish the job

 

Just reading online commentary and saw these charts

 

No, I would agree with you. Bottom line = make hay while the sun shines. if you can maintain I/O for your INV property debt whilst simultaneously directing all available cash flow ( salary, bonuses, commissions, tax refunds, cash cow surpluses if you have them, etc ) towards PPOR P&I debt reduction, that's the sensible approach, unless as you suggested, I/O repayments eventually became more expensive than P&I repayments for the same INV debt. Otherwise, its just not logical to direct anything but the minimal amount possible towards INV debt while that money could otherwise be directed towards the reduction of non deductible, non income producing PPOR debt.

Saved interest caused by extra repayments made on the non income producing, non deductible P&I debt is another calculation that should be considered. We know that paying an extra $600 per month ( @7200 per annum or thereabouts ) towards non deductible debt for example, amortises a loan much more quickly. You can see how this has the potential to impact non deductible debts of 300K @ 4% P&I , 400K @ 4% P&I , 500K @ 4% P&I below...



So there's quite a bit to consider. There's the immediate monthly cost. I/O at rate X v P&I at Rate Y. There's the longer term outcome to be considered.... PPOR debt reduction and the associated saved interest, and the associated CGT free profit when you sell , versus the CGT treatment of INV properties.

In the end, I believe that paying down PPOR debt as aggressively as possible, whether that's for even just a few short years, will serve anyone and everyone well. INV debt always gets a helping hand because its income producing and it offers deductibility. Of course, the deductibility is typically in arrears unless you utilise monthly variations, so you often still have to have sufficient cash flow to HOLD until the tax man gives you your nice refund cheque.

This is especially true when you take the earlier arguments into account. if you can use the first 5 years I/O to pay down as much debt as possible, you should have made huge inroads into your PPOR debt by then. You can then either seek to refinance or extend I/O for another 5 years ( right now it doesnt look possible, but in 5 years time the quota may well have relaxed a little and extending I/O or refinancing I/O debt may be easier than it is during this extreme transition period we are entering) or you can roll out to a new 30 year P&I term, which should be pretty straightforward as a general rule. Either way, you'll have made big inroads into your PPOR debt, which will make any future INV P&I cliff far less threatening.

Just another reason why some sort of extra income /cash flow is going to prove really handy for many readers, moving forward.