IO loan with offset vs P&I

I currently have all my loans in interest only, which are due to roll over to P&I in 2020. The loans are all for IP which I would like to maximise tax deductions on interest.

We have been responsibly saving and getting ready for the increase in repayment when it rolls over to P&I. We can afford the repayments if we cannot refinance to another IO period.

Let's say my investment loan balance is $500K today
PPOR loan has $200K outstanding, already has $200K in offset, essentially paying $0 in interest
In the last few years we have been putting all our savings into the PPOR offset and now figuring what to do next now that the offset balance has reached the outstanding loan

With IO:
as long as we keep saving into the offset account for the investment loan, the savings will eventually exceed the loan amounts like we did with our PPOP. but we can access the cash any time. We would be effectively reducing the interest over time.

With P&I:
Repayment will increase. Having the money going into the offset account, it will go towards paying down the loan.


What are the pros and cons of IO vs P&I for investment loans in this situation?

Will we be paying off the loan in the same amount of time?

I guess I'm thinking ahead of the peak P&I rollover in a couple of years time

Debt Bomb: Fears of housing 'fire sale' as interest-only loans roll into principal plus interest

 

is the IO rate more than the PI rate?
If so you have to consider that having an IO loan will result in you having higher rates. the cash flow may be better in the short term, but it will result in a loss of money long term.

is the owner occupied rate higher than the investment rate?
If so keeping large amounts of cash in the offset will cost you money because that cash could be recycled into the owner occ loan and out to the investment loan saving you money.

 

Have you actually figured out what tax deductions you're actually missing out on with principal & interest repayments?

I've done some basic analysis. I'm not an accountant so I'm not sure if it's 100% accurate, but I suspect it's in the ball park:

The assumptions are:
* $500k loan
* 30 year loan term
* 5 years interest only at 4.80%, then 25 years at 3.89%, vs 30 years at 3.89%.
* The marginal tax rate of the borrowers is 30%.

* In the first 5 years, you'll pay down about $48,500 with P&I repayments.
* During that 5 years, you'll miss out on a total of $8,172 in tax deductions.
* After that first 5 years, at most the paid off principal will mean you miss out on $567 per year. This will reduce over time as the loan is not on P&I repayments.

* Over the life of the loan, having I/O repayments for the first 5 years will get you an extra $16,410 in tax deductions
* However those tax deductions will come at a cost of an extra $38,291 over the life of the loan (inclusive of the extra tax refunds).

Modelling an offset account into all this is far to much for my walnut sized brain to contemplate, I'm assuming you only ever make minimum repayments.

What I do know without a doubt, is that an interest only loan will cost you more, unless you've got the entire loan offset from day one.

 

The big problem I have with IO lending is that people very naturally fall into the trap of basing their cashflow and repayments on the IO amount and not the P&I amount. Any excess funds/principle saved in the offset is used. Although people say they "get it" at the beginning of the IO period - its a different story at the end of the term.

IO has its strategic benefits which has been discussed heavily on the forums but I think P&I repayments suit a lot of people.

 

So I have a pretty nasty calculator which probably has many holes which the experts on here can pick at - so I hope they'll be nice and correct me so I can make updates to it.

Assuming you have an offset which is always keeping your current PPOR at $0 interest, you're going to be paying $0 Principal if it's IO or all the Principal.

I'm going to use @Peter_Tersteeg 's interest rates for continuity sake in my spreadsheet but only focusing on the PPOR of $200k
The 1st worksheet - left table is looking at your PPOR for the first 5 years of IO with the right table looking at the remaining 25 years at P&I.
Since you have a capped offset, you're not paying anything for the first 5 years. Now usually you don't have a capped offset but you're working your way up. Since it's variable, rely on your previous bank statements to determine how much interest you've been paying.
The remaining 25 years shows what your repayments will now be. As you have a capped offset, your repayments contribute to all the principal portion.
By month 192 you should have paid all $200k off.

The 2nd worksheet - the table is looking at your PPOR for the entire 30 years at P&I. Your repayments are $942 so you're only saving $101 in cashflow but the interest/tax deductions are a completely different area which I'm not going to get in to. I'm just looking at your Q:

At this interest rate you can see it's month 213 when the entire $200k is paid.
You can muck around with the figures all you want but
* the cashflow saved with IO should never be spending money
* rates change all the time, you can plan as much as you can but then new factors come in to play

If you have plenty of offset "overflowing", consider getting an offset for your other investment properties if you haven't already.

 

I think in this case there is no need for calculations like this as the main residence loan is essentially paid off. So there would be no tax savings between the 2 options of:
a) paying PI or
b) paying IO with offset

In fact there would be savings with the PI route as this would result in a lower interest rate. but this comes at the cost of worse cashflow in the short term because of the higher repayments.

this assumes only one entity involved. Where there are properties with different owners things will be different.

 

That is so true... Even we consider ourselves as responsible with our spending and good at saving, we almost fell into this trap until my friend who works in lending pointed that out to me...

I remember asking my broker when I took out the IO loan in 2015 what's going to happen in 2020 when the IO expires, and she said, "we'll worry about it later. Most likely rent and your income will increase enough to cover that. If not you can always refinance..."
The reality is rent has not increased since 2015, and our income has only increased by 12% since 2015... plus having kids along the way isn't going to help with our borrowing capacity...

Damn I hope the IO rolling over to P&I isn't going to cause too much panic to the market...

 

Let's say by the time P&I kicks in in 2020, I manage to save $100K cash
PPOR essentially paid off (loan balance $200K, offset $200K)
Investment loan $500K outstanding

Can any of the experts here point out if there is any mistake in the calculations for the two options I'm considering?

Option A:
$500K loan balance
$100K in offset
5 years IO has lapsed, remaining 25 years P&I
interest rate: 3.89%

According to this calculator:
Offset Calculator
Monthly repayment $2,608.91
Revised loan term: 20 Years 11 Months
Total paid: $654836.41

Option B:
Pay down the $500K loan with $100K cash, loan balance reduced to $400K
5 years IO has lapsed, remaining 25 years P&I
interest rate: 3.89%

According to this calculator:
Home Loan Calculator
Monthly repayment: $2,087.13
Loan term: 25 years
Total paid: $626139


1) Option B will save $28697 over the term of the loan.
2) Monthly repayment of Option B will be less than Option A, may help with cashflow when time gets tough
3) Option A will pay off the loan 4 years 1 month earlier
4) With Option B if I redraw the $100K to spend on say a car, the loan will be mixed, only interest on the $400K will be deductible (man i won't know how to calculate the amount of interest deductible)
5) With Option A if take out $100K from the offset to spend on a car, interest on the full original $500K loan will remain deductible

Can any of the experts point out if there's anything I've missed in the calculation and the reasoning?

 

I won't verify your calcs but you appear not to be taking into account offset cash.

4) loan will be mixed
5) no

 

It's common for people to look at debt as a terrible burden and they want to reduce liabilities in any way possible.
Since you mentioned all your loans are currently IO, is your PPOR going to roll over to an IP down the track?
Are you still in your accumulation phase for investing?
I was asking questions in another thread about borrowing capacity (paying down debt vs keeping cash in an offset). Personally, I'm in the keep money in the offset camp and if I'm short on borrowing, I have the choice to pay down debt if I want to use funds from the offset.
Looking at the repayments, if you're going to stay on IO, you're always going to be paying more in the "Total paid" area because you're not paying any principal down. The advantages are cashflow along with interest deductibility.
You could pay down $100k and later draw equity via a split to use for investment (subject to assessment). Or you could use your offset (assuming it's all your cash and no borrowed money is in it) for freedom of personal use. The calculations are right but you can even be fancier and have Option A & B by paying down the $100k and still make repayments the same value of Option A ($520) which will drop your total paid down to $594830 a reduction of 15 months.

How do you want to make your money work for you? It comes down to your strategy.
Best IO rates

 

In my case, the most benefit I got was when the offset was still less than the outstanding loan so I put every spare $ in the offset to reduce the interest each month. I haven't done the calculation, but suspect the interest saving on (IO+offset) would equal the benefit of P&I, until the offset = loan amount.

Once the offset = outstanding loan, I found the only ways to 'eat away' the Principle was making extra payments or increase repayment amount.

 

Your IO repayment will be much less than P&I repayments. Yes the interest saving for IO and P&I will be the same but if you're in P&I, your repayments will be predominantly principal payments.

If offset = outstanding loan, your IO repayments will be $0 but your P&I repayments = 100% principal payments, which is 'eating away' the principal value.