IO or P+I

Hey Jess I'm a newbie to all this, may I ask whats the reasoning for opting IO even if the interest rate is significantly higher than P+I?

My understanding with P+I is that even though in the short term you have less cash flow, when you need to buy the second property (in my case say 2 years time) you can redraw the equity from the property right? For the purposes of buying another property, isn't that functionally the same as IO? i.e. instead of having the principle in the property you have it as cash in an offset account. I know that technically with IO you have easier accessibility to that cash, but in my case I don't foresee myself making any significant purchases until my next property and the extra loss of cash flow from P+I won't affect my lifestyle.

 

The difference is that any equity you access from your first property is only deductible when using it to buy an IP. If the first property is an IP and the second is a PPOR, you end up with a smaller INV loan and much larger non deductible debt on your PPOR.

 

That is very true
After years of paying only $.3k (and nothing in some years) principle the payments lifted to $3k (per day)
It does happen!

 

Yes especially if interest rates go up significantly. We will need to factor this into our exit strategy.

 

As Peter said earlier in the thread, it seems that it's no longer a no-brainer to go IO on a loan for an IP. The accountant I saw to double check my loan structure, who seemed pretty knowledgeable, gave me the impression that it was a 50/50 call these days and his preference was P+I.

Same rationale that has already been stated on this thread - under the tighter lending environment it may be looked on favourably in future as it demonstrates serviceability (by paying down some of the loan) and also the bottom line is you are effectively building equity by paying it down. Plus the interest rate will be better.

I will wait to see how big the difference is in rates before deciding, but as I don't have a particularly aggressive strategy I may well end up deciding take the hit to cash flow in the short term by going P+I straight away.

 

In my experience many accountants are super conservative. I've lost a few deals to accountants telling their clients to save a 20% deposit because LMI is the devil.

 

Yes if you can afford the repayments now then it might be a good idea to go P & I now while interest rates are low and save your IO term for when you may need it in the future when cash flow is required.

 

Forgive me for the very basic question, but isn't it also the way that you can't necessarily access 100% of what you've paid down off the loan? Or is it as simple as that? Ie if in paying PI repayments I pay off 30k, can I definitely get 30k out for the next purchase? If it's not guaranteed, IO with an offset building up the 30k would be better right?

 

Yes - you can't just redraw your P&I payments, you can only redraw what you've put in over and above the contracted payment. So if your P&I payment is $2000, and you're putting in $2100, you can redraw that $100 as you please, but the principle payment is not redrawable without a new application/refinance. Your loan limit is being reduced with every P&I payment.

Of course you can refi to access equity, if you have servicing capacity - but many people with a few properties won't have this option.

 

Non-resident here (living overseas, but Au citizen) - St George just sent me a letter saying the new rate for IO for non residents has gone up over 200 basis points from 4.95% to 6.98% lol.
I guess this is their way of forcing people onto P&I to reduce country-wide debt (?). Luckily I only have a 100k loan, but still, 200 basis point rise in one go is insane.

I'm actually refinancing to another bank (and making another purchase) and there is no IO option available for non-residents at all.

Might fix with my P&I because if they decide to up the rates 200 basis points for P&I loans for non-residents, it will be a problem.

Interesting times.

At least my repayments did not go up from 0.3k to 3k per day.

 

200 points in one go !!!!
That is insane!

 

Hey guys, what is your take on fixed or variable interest?

I think the banks are having a crack at investors with a lot of IO loans, forcing in one way or another people to swap to P&I. This will do a bit of screening, select the real investor (the one with a plan) and force to sell the "speculator". 1/2 years? I guess this will go on for at least 5 years.

Number of IO loans has been discussed for a while, the natural selection will be when IO turns to P&I.

Based on the above the gap between IO and P&I will get bigger.

My recommendation is P&I - variable if you can afford it. Also focus on buy well and not buy a lot.
You can still refinance when things change again (I guess).

 

With the bulk of the repayments over the first 5 years being interest, It can make a sense to go P+I now. With banks offering Investment fixed rates under 4%, the interest differential can be ~1%. Cash flow wise the interest rate differential means the repayments are not to dissimilar now maybe ~.50%.

 

Really needs to take into account personal situation to make the call.
If no set plan given the difference in cost P&I would be a likely default option now.
I see the gap continuing to widen, soon will be pointless being IO.

I timed it well and have fixed 3yr @ 3.99% w/ 5yr IO for most of my loans.
By the time the fixed and IO expire the rent should have increased a reasonable amount.

 

One for the brokers. Which lenders are still allowing I/O for loans > 80%? The majors no longer allow this so who else is left for established homes and construction. Definitely a different mindset needs to be taken over our traditional thinking that I/O is best for us investors going forward.

 

There still are a couple doing this - Liberty, Pepper and probably a few smaller lenders. You've gotta look to find them these days.

It's a total shift in thinking now - what was 'best' yesterday is not the same as what's 'best' today. I'm finding that I'm recommending P&I a lot more than I ever did previously, and now many people have little choice but to pay P&I if they want to buy with a small deposit.

Interesting times. Strategy has taken a 180 degree turn.

 

Great write up! You really are the construct master

Something else to consider is if you are paying LMI to settle the land. This could be a disaster if the value once build contract in hand comes in low.

 

Brilliant summary!
I would just add the other IO advantage is maintaining the ongoing tax deductibility of the loan.
If your plan is to ever turn an OO into an IP then IO may be worth considering..

What however was once a no brainer now requires some serious number crunching and future planning.

This is a quick best effort crunching exercise, I may be wayyyy off!
Let's assume the difference in IO/P&I repayments is $2,500 a year (.50bps on a 500k loan). Let's also assume the additional IO surplus is being stored in an offset account so the only repayment difference is in-fact the IO loading. This means over a 5 year period the IO loading cost is approximately $12,500.

If we take a 500k loan at 4% paying P&I over 5 years then at the end of that period the loan amount will be approximately $452,500 meaning you have paid $47,500 in principal.

Now lets say we turn this property into an IP and we had paid interest only and can claim a deduction on that extra $47,500 in unpaid principal and lets keep it simple that interest rates are still at 4.5% for IO (Lazy RBA). The result would be $2150 (rounded) in additional interest repayments per year. Let's assume a tax bracket of 37% the result is approximately $800 in additional tax benefits.

So without anything changing the ROI is 15.62 years.

I'm sure I have mucked something up! haha

 

So take home message in this scenario is that IO costs more in this instance?!

 

I could have calculated this incorrectly but if I am accurate then the take home message is in almost all cases the IO loading is going to cost you more than the potential tax benefits.

Unless you plan on holding the investment for a very long time and are in a higher tax bracket the ROI would be returned sooner.