Loan Tip: At What Point does IO = PI?

Recently the interest rate gap between interest only (IO) and Principal and Interest (PI) loans is widening.

Generally IO loans were preferred for investments because this allowed for minimal repayments on the deductible loan and allowed the non-deductible loans to be paid off quicker. However now doing this will result in extra interest being payable to have the benefit of interest only loans.

I wanted to work out at what rate difference would the repayments on a more expensive IO loan work out to be the same as a cheaper PI loan.

Example
$500,000 loan
Interest rate of 4.5% PI
30 year term

The monthly repayments on such a loan would be approx $2,533

To get interest only repayments of $2,333 per month we would have to work backwards

$2,533 * 12 / 500,000 = 6.08%

Now let's work forwards to check this
$500,0000 x 6.08% = $30,396 per year
divide that by 12 = $2,533 per month

So in this example rates would need to be 158 basis points higher for the IO loan repayments to equal the PI repayments for the same loan amount. This will vary depending on the loan term and the interest rate.

Note that this doesn't mean you should not take a PI loan unless the difference is greater than this amount. I haven't yet got my head around the questions "when would it be more beneficial, from a tax point of view, paying PI on an investment loan while you still have non-deductible debt?". I might tackle this in a future post.

 

Timely article.

Just one thing, when you say "I wanted to work out at what rate difference would the repayments on a cheaper IO loan work out to be the same as a more expensive PI loan." I think you meant "cheaper PI loan... more expensive IO loan"? I'll delete this later but just thought I'd mention it since its a very helpful post.

 

great post Terry, i was also thinking this yesterday, as many variables to factor in.

 

Thanks a lot @Terry_w, I think you mean 158 basis point higher rather than 1.58% higher? As 6.08% is 35% higher than 4.50%.

Can't wait for this post!

 

Indeed. You are right!

 

so basically its worth going P+I until you can offset a decent/ the full amount and then go back to IO to stop the principle being taken down any further than you need it to be and also increase cash flow . at the expense of .5% or so interest rate

 

Good post @Terry_w !
Will have to do the calc on my loans.
Keen for your next post on tax, as I still have a huge non-deductible debt.

 

Well explained, Terry! The spread gets even larger on 25 years P&I

 

its showing as 1.58 basis points now?

isn't 158 basis points 1.58%?

what am i missing as i dont understand?

 

not necessarily. If i say 1.58% more than 4% then it would be worked out as 4.% x 1.58% which would be different to 4% plus 1.58%

 

ah got ya.
so it should say 158 basis points or 1.58% ? rather than 1.58 basis points?

 

For loans that are reverting from interest only to P&I....is it any easier to request an extension of the loan term rather than an interest only extension? ie does an application to renegotiate the loan term trigger the same onerous requirements?

 

Yes and Yes

Every investor should, ideally, be extending loan terms back to 30 years periodically. This will lower repayments a bit.

 

can you split your loan . as an example 30% is IO and partially or fully offset this portion and the other 70% is P+I?

That way the P+I repayments are going to be lower on a lower loan amount with a lower interest rate.
and
the IO portions you aim to offset with your buffers negating the higher price?

gives you more cash flow than full P+I with some benefits of IO?

 

Yes you can

 

But the io portion will be at io rates.

 

I think he said what he meant

 

Good thread terry for some thinking!

I guess I would rather maintain the IO on the IHL stuff, and focus on chipping away at my OO loan

 

if offset it wouldn't matter what the rates are and would lower the P&I repayments

 

Having an offset balance doesn't reduce p&i repayments, it just reduces the loan term.