I/O vs P & I for Investment loans

Discussion in 'Loans & Mortgage Brokers' started by Investments Seeker, 8th Aug, 2017.

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  1. Investments Seeker

    Investments Seeker Member

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    Hi Guys

    I have two I/O loans i am currently considering whether its worth changing to P & I at fixed rates for 2 or 3 years. Obviously the P & I has higher repayments than IO at the moment but given the APRA moves the IO interests have been moving higher. I still have an LVR > 80% so fixed rates am getting are 4.89 & 4.94 % for 2 or 3 years respectively.

    I guess the easy part is getting the repayments and difference between the IO and PI. What i am failing to evaluating though is what it means in deduct ability. I am assuming there is a tradeoff paying extra for the principle but also a loss in savings from IO. But how to quantify each hence make a judgement which is the better options is difficult.

    Any help will be appreciated to break it down to numbers
     
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  2. BKRinvesting

    BKRinvesting Well-Known Member

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    Interest paid on IO = x
    Interest portion paid on P&I = y
    Total P&I payment = z
    X-Y= interest saved
    Z-X = extra funds needed to save that interest
    (X-Y)/(Z-X) = indicative ROI on extra cash outlaid pre tax
    Tax rate = TR
    X * TR = indicative tax reduced on IO
    Y * TR = indicative tax reduced on P&I
    (X-(X*TR))-(Y-(Y*TR)) = indicative interest saved after tax

    Hope that helps
     
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  3. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

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    I did a quick analysis of the tax outcome differences using the following parameters:
    * $500k loan.
    * 5 year interest only period.
    * Earns $80k or less (30% tax rate).
    * Rate difference of 0.5% (4.5% P&I vs 5.0% I/O).

    Over the 5 year period, you pay of approximately $20k in principal if you choose P&I repayments, so the deductible difference is really a combination of the interest rate difference.

    Thus the difference in tax deductions peaks at year 5, just as the I/O period ends. The extra interest you pay across the $20k principal at this point is:
    $20k x 5.0% = $1,000

    Using a 30% tax rate you're realistically missing out on $300 per year in tax deductions.
    $1,000 x 30% = $300

    For comparisons sake, with the rate difference of 0.5% across $500k, you'll pay $2,500. When considering the after tax cost this becomes $1,750
    $500k x 0.5% x 70% = $1,750

    This means you're paying $1,750 extra interest to get an extra $300 in tax deductions.

    This would be the difference for variable rates. If you start to look at the extreme rate difference, say a fixed rate vs variable for a 90% loan, where the rate differences could be as much as 1.4%, you start to get the situation where you're paying more than $4000 per year for a $300 deduction.

    These figures are on a per-annum basis.

    My conclusion is that you shouldn't choose interest only repayments for the tax benefits.


    * Note that I'm not an accountant. This is amateur reasoning and it only follows one path of reasoning, there may be others more relevant to individual circumstances. Consult an accountant if you want qualified advice.

    ** There was a typo in the original post. It initially stated it costs $750 extra interest, it should have be $1,750.
     
    Last edited: 8th Aug, 2017
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  4. Jess Peletier

    Jess Peletier Mortgage Broker & Finance Strategy, Aus Wide! Business Member

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    This needs specific advice based on your own plans - the fact is that for many people changing to P&I is the easy part - if you need to change back it's definitely not guaranteed that you'll be able too.

    If you're done buying, no problem. If you're not, I'd wait until you've finished.
     
  5. Investments Seeker

    Investments Seeker Member

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    Thanks Peter & BKRInvesting you have correctly laid out in a simpler way to understand the figures . Much appreciated. I guess that is the magic question how much are you paying in interest to gain how much deductions. If not great then P & I makes sense as you also be contributing towards the principal.

    In fixing the loans , its a matter of whether you foresee need to extract equity within the fixed period hence incur breakout fees. If the LVR is likely to drop to below 80% then fixing can work against you if plan is to use it.

    Once again thanks for all your comments. Lets keep investing the eye on the ball
     
  6. Investments Seeker

    Investments Seeker Member

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    @Jess Peletier thanks for the comment, valid indeed for long term and am definitely in the acquiring phase so might not be the best option to lock now
     
  7. Investments Seeker

    Investments Seeker Member

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    @Peter_Tersteeg just one more question in your calculations if the Income and tx bracket was higher than 80k & 45% how will that compare in numbers terms. Thanks
     
  8. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

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    Where I've used 30%, you use 45% instead.

    Where I've used 70% (interest cost after tax deduction), you use 55%.

    You end up paying $1,375 extra interest to save $450.
     
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  9. Investments Seeker

    Investments Seeker Member

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  10. Corey Batt

    Corey Batt Well-Known Member

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    Good analysis there Peter - it just highlights the reality of the current environment that it should be more a case of justifying utilising interest only.
     
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  11. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

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    I've been reviewing these numbers and have realised there's an error in the amount of principal paid off during the first 5 years, it should be closer to $45k, not $20k (I should have had more coffee that early in the morning).

    I've also extrapolated a lot of other figures which lead to various conclusions. Here's the guts of it, using the same initial parameters of:
    $500k loan
    4.5% P&I rate
    5.0% I/O rate over 5 years
    30 year total term
    30% tax rate

    During the I/O period, there will be a cash flow saving of $27,000.
    Across the life of the loan, choosing I/O for 5 years would cost a total of $32,700 more than having an I/O period of 5 years.

    A higher tax rate of 45% mitigates this a little, the cash flow saving is the same, but the I/O rate will cost $25,690 extra over the life of the loan.

    If you choose the rates wisely and go to extremes with the following parameters:
    4.0% P&I rate
    5.3% I/O rate

    You get an initial cash flow saving of $10,724, but a total extra cost of $45,435 with a 30% tax rate and extra cost of $35,700 with a 45% tax rate.

    At this point I've got some calculators working. I intend to refine these and then I'll put together a more comprehensive analysis.
     
  12. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    I think in most cases where there is a rate difference between PI and IO then it would generally be better to go PI.

    This may hurt cash flow in the short term but the effects can be reduced by taking PI loans back up to 30 year terms and doing this every 2 to 5 years, on investment properties, to lower the repayments.
     
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  13. Investments Seeker

    Investments Seeker Member

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    @Peter_Tersteeg & @Terry_w thanks guys for reviewing much appreciated for the comments and analysis it makes decisions better when you have numbers in front of you. Looking forward to your comprehensive analysis :)
     
  14. TMNT

    TMNT Well-Known Member

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    can someobody please explain whats going in todays market and going fwd with the apra changes and assumptin of lending tightening

    it seems PI for IPs var and fixed are 4.5-5%
    yet IOs are all 5-5.5%

    there seems to be a lot of talk of 'up to 8 rises in teh next 2 years'

    would this not mean the best is to fix for 3years plus or even 5?

    obviously going pI reduces cash flow sigifnicatly, even if the rates are lower compared to IO
     
  15. TMNT

    TMNT Well-Known Member

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    might add another question
    thanks for your analysis peter, its good for people who are bad with finanance calcs

    assuming you arent intending to sell

    what are people doing with PI fixed 1,2,3,4,5 years

    it seems 2-3 is the cheapest,
    5 years is getting a little expensive

    I also need to consider what the market may be doing after you come off the 2-3 years fixed rate......
     
  16. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

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    Right now we're going through a lot of turmoil with APRA. It's lead to increasing rates for investors and for interest only loans, as well as very significant lending restrictions. I like the 2 year P&I fixed rate at 3.88% because whilst it's a short term solution, it's very cheap and a long enough period that we'll likely be through all the regulation reviews by that time.

    When this fixed rate expires, we'll have a reasonably good idea of the playing field will look like moving forward. Right now it's impossible to give anyone a lending plan simply because the rules change constantly and the only thing that is predictable is that the rules will become more conservative.

    I/O fixed rate for 3 years are around 4.5% with some lenders. Given the equivalent variable rate is about 0.35% - 0.80% higher (depends on the lender), this is probably a fairly good deal. Even 5 year rates at about 5% are probably going to be cheaper than variable rates given there's very little expectation of rates dropping over the next few years.


    As for market predictions, it really depends on which market? What I do see is that lending criteria will become more restrictive and this will lead to further slow downs in certain markets. They'll likely flat line for an extended period while rents and incomes catch up.
     
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  17. TMNT

    TMNT Well-Known Member

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    I too agree that rates wont come down at all,

    whether there will be rises or flat line I have no idea, but the cynical side of me thinks that there might be a few rises, which I guess means 2-3 years would be the best to fix,

    the hard part i believe is the benefit to non benefit ratio for the 5 years as the rates are noticeably higher
     
  18. Jess Peletier

    Jess Peletier Mortgage Broker & Finance Strategy, Aus Wide! Business Member

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    I've fixed 2 of my IP's for 2 years - one IO and one P&I - great rates but also long enough to get over the APRA hump. Leaving my PPOR variable for now - fixed is too restrictive for the aggressive debt reduction/debt recycling strategy I'm implementing.