PI vs IO 10yr analysis

Further to some recent threads i thought id work out some figures on my portfolio as im paying P&I on everything at current, and whilst i enjoy seeing the mortgages come down in chunks each month i cant help but wonder about the opportunity cost along with loosing deductions slowly each month/year

Feel free to critique / discuss - hope it helps


Below is assuming 10yrs P&I @ 4% vs 10yrs IO @ 4.4%

P&I
Loan $500,000
$2386.00pm ($286,446)
Loan remaining at 10yr $393,919 –
Total paid Principle $106,040 / interest $180,368
Payment split at 10yr $2386 = $1070.00 P / $1316.00 Interest



IO
Loan $500,000
$1843pm ($221,160)
Loan remaining $500,000
Total paid $221,160 interest -
Payment split at 10yr if converting to P&I = $3136 = $2014 P / $1122 interest

Conclusion is a saving of Saving of $40,754 in actual interest however you loose deductions of $31,812 at 30% marginal rate so only an actual saving of $8,942

Variables
If we then take into account opportunity cost of the principle payments over 10yrs $65,286 we would then need to gain higher than % ROI per annum to make it worthwhile,
at yr10 we would also have an extra $9000 in re-payments from IO potentially converting to 20yr PI

Something im unable to Quantify is the lack of servicing by being on PI potentially limiting the leverage of another properties CG, however given the current climate i dont see being on PI as such a bad thing, as at yr10 your loan has actually reduced $106k giving you further deposits

For my personal circumstances im much more comfortable running P&I and reducing debt in this environment.

 

Thanks Rolf,

Can you advise, from a serviceability standpoint only, does P&I across a portfolio impact you any worse than if you were running IO across it? Obviously on 1.5m for example your rep-ayments would be $30k different, but am i right in saying lender assessment rates factor in P&I anyway so would not be any worse in serviceability?

 

A 10 year IO period will significantly impact your servicing with all but the non-conforming lenders as Rolf outlined.

I'd strongly recommend a 5 year IO period (most lenders won't give you 10 anyway), then review and possibly roll over after that expires.

 

10 year IO is rare so it might be best to base your analysis on 5 years.
You could also potentially keep resetting the loan back to 30 years to make the PI min repayments less than the IO repayments eventually.

 

1) Another reason to go with IO is a person is considering moving into retirement, or scaling back to part time work as they transition to retirement. He or she may be able to comfortably manage cash flows with IO but not with P&I. In that scenario, I guess it pays to plan ahead and convert to IO while you have a full time job and income, given the IO conversion is a full application as I understand it.

2) A final question on the IO application. Is the servicability check the standard check a bank would do when assessing a loan (eg for a straight refinancing)?

 

Sorry i should have clarified, i was only using 10yr IO as a longer term example of savings/cost. Could have used 5yrs and would have just had a lesser result

My main reason for working this out was purely trying to figure out which way may be leaving $$ on the table like for like, saving on interest vs keeping full deductions over 10yrs

As you pointed out Rolf, Using that principle in an offset, other things that obviously make the calcs harder to figure out

Opportunity cost of using that portion on another property if finance allows
Using this portion for other investments, shares etc
Dividend recycling
Paying down principle & re-borrowing

Many ways to skin the cat just trying to work out best use for my situation

 

IO mortgages can be a good option, IF the extra money that would have been paid is actually being redirected somewhere else productive (ie, paying off non-deductible and / or higher interest debt).

It's a bit like having a credit card though. They can be good tools, if used correctly. However my experience is that 'most' people in general don't use these financial tools in the best manner. That money they are 'saving' on payments monthly, isn't actually being redirected in the best way.

For myself, I only ever go P&I, because I know myself well enough to recognize that although I know how I should best be redirecting money and structuring my finances, I won't adhere to that strictly. There will always be some other expense that will pop up, where it is more convienient to put that money. (I choose not to have credit cards for the same reason). We also throw extra money on our mortgages whenever possible (not just in an offset, which we keep enough just to cover emergency expenses and such). The benefit of that being that now have greatly reduced our debts and have a LOT of equity.

There were 'smarter' ways where we theoretically could have gotten in a financially better position a bit sooner. But if we had gone that other route, I know in practical and real terms, we would actually be worse off then we are now.
And don't underestimate the impact and importance of the sleep at night factor.

Anyway, my point being, definitely do the math and weigh up all the options. But in making these types of decisions, its not all just numbers. You need to be ready and willing to be completely honest about yourself and your spending habits and ability to follow through on the plan.

 

The attached period shows the outcome of a 10 year IO period on $500k, assuming a 0.40% rate difference for IO vs P&I, and assuming you're on a 40% tax rate.

About $60k in cash flow benefits over the IO period of 10 years, but overall the loan will be almost $55k more expensive over the total life of the loan (including the tax deductions).

The impact on serviceability of a 10 year IO loan is very significant as well. I've had a few clients wind back existing IO periods just to qualify for another loan. The exact effect of this really depends on individual circumstances.

The justification of IO vs P&I is simple. You only save money if the cash flow benefit during an IO period is direct to paying down non-deductible debt or if you use it to acquire other assets. If you're not going to use the money wisely, you're better off paying down principal right from the start.

I don't think using IO to make your servicing better with Liberty is a good strategy. I have very few clients who are happy being with Liberty. They all acknowledge that they were told their rates would likely go up and Liberty is taking advantage of their niche, but experiencing 6%+ when other loans are on 4.5% isn't pleasant.

 

I'm curious to know why people are doing their analyses with 5 or 10yr IO periods? Why not just refinance and continue on IO indefinitely and maintain the permanent deductibility?

 

You could choose that, providing your strict and use any money that would be going towards principal in the offset, or in a better means that gave you a higher return than the interest rate. As some have mentioned above, I’m also not as strict at making sure every cent is used in this way and find it much easier to stick to paying down principle and being happy with saving interest.

 

Some people plan on doing this, only to run into trouble down the track when their circumstances change or the bank decides for some arbitrary reason not to renew the IO term.

You also need to ask yourself at which point is the deductibility more important then paying down / off the mortgage. Is the value of the deductible on your tax better then the amount you pay interest in the extreme long term?
It will really depend on your overall investment strategy.

I'm all about buy and hold, forever preferrably. Let the kids worry about selling the assets. As such being completely mortgage free before I head into retirement is a desirable ideal.

 

Agree Liberty is a means to an end. I’m currently refinancing my PPOR loan from Liberty to a Big4 because their offset isn’t a genuine offset account being a non-bank, so I wanted something safer to park money in. Liberty is the most generous when it comes to serviceability, so you either take the risk with a nonbank and buy the property, or fall short of serviceability with banks and miss out. Their PPOR rates are not bad.

But at the same time I’m also getting an IO loan from Liberty for a new IP, paying 2% *more* than other banks’ variable rates because of their loading for investment loan and professional investor. Yes paying that premium isn’t great, but they are the only ones lending the amount required so again it’s a choice - do I want the property or not? And I’m thinking IP interest is deductible anyway. But agree it’s not for long term so it needs an exit strategy eg offload a property down the track to reduce debt to enable refinance away from Liberty back to a bank with cheaper rates.

 

How does the calculation look if what would be the principal payment is loaded up in the offset, you aren't reducing the loan value, only the interest payed on the total (this is assuming there is no non-deductible loans to offset)?

 

I think another assumption to challenge here is that the principle paid down on P&I is "locked away for good".

Assuming you meet serviceability there is no reason you can't pay P&I for a few years, then refinance to release this equity. If the released funds are set up as a new loan split you can do whatever you want with it - debt recycle to shares or property expenses, deposit for the next property or some other non-investment purpose.