Interest only or principal & interest loans: Which loan strategy to adopt?

By Graham Turnbull | 15 May 2014
Most investors take advantage of the interest only mortgage payment option to maximise their cash flow. But as Graham Turnbull explains, there are also many advantages of opting for principal & interest repayment.

In light of the current low interest rates, many of our clients have been asking us whether it is better to adopt interest only (IO) or principal & interest (P&I) repayments on their loans. On face value, paying P&I makes sense when rates are low, as it allows you to repay the loan faster. However, there are situations when IO may be the better strategy to adopt. Firstly, let’s clarify how they both work.

Principal & interest
P&I loans are designed to repay your loan over the defined loan term – usually 30 years. Your lender calculates your repayments including the interest charged for the repayment period and any loan fees, plus a portion of the principal balance. Under P&I as your loan balance reduces, so does the interest component (assuming the interest rate remains constant), meaning your scheduled repayment pays off more of the loan principal, as the loan term progresses.

Interest only (IO)
With IO repayments, you are only required to repay the interest portion (plus any fees) on the loan over the chosen IO period offered by the lender. 

Upon expiry of the original IO period (usually from 1–10 years), you must request and negotiate a new IO term if desired. To ensure you are not caught out, it is important to know what your lender allows at the IO term’s end before it comes around.

Using the IO strategy
IO loans are popular with investors for several reasons, largely on the assumption that the property asset is going to increase in value. Some investors maximise their interest repayments and use the tax deductibility of interest on their loan repayments. The higher the loan balance and longer the IO period, the more an investor can maximise their tax-deductible benefits. 

IO can offer cash flow benefits by freeing up the “principal” component of each repayment for other uses.  Lower scheduled repayments allow many of our clients to benefit by accumulating their deposit for their next property purchase. Other clients take advantage of the opportunity to pay off other non-deductible personal debts (usually on higher interest rates) such as car loans, credit card debt or personal loans. Critically, this requires a high degree of discipline to ensure the principal is not diverted to other uses. Without discipline, you could be worse off. 

IO may also offer the option for investors to prepay interest for the upcoming financial year, allowing them to claim next financial year’s benefits in the current one. As an incentive, many lenders offer some rate concessions if receiving their interest paid one year in advance! Another advantage with most IO arrangements is that many lenders still allow flexibility to make extra repayments. So, when IO is being used as a way of reducing loan repayment amounts, principal reductions can still be made as needed.

Issues to be aware of if adopting an IO strategy
Increases in living expenses or interest rate during the IO period can mean that, when an IO loan converts to P&I, the resulting repayments could leave you on a much tighter budget or exceed your ability to pay. 

At the end of an IO period, lenders will assess your serviceability on the remaining loan term. So for example, on a 30-year loan, coming off a 5-year IO term leaves you having to repay your debt based on the remaining 25- year term. 

Lenders will not rely on any intended asset sale to repay the debt either, even if that’s what you have in mind. You must be able to demonstrate your ability to repay the outstanding loan balance and obviously this will compound for any extended IO periods. 

Another potential disadvantage of the IO strategy is being overexposed should your property’s value fall (ending up with negative equity in your property is not smart investing!) So, although an IO strategy can initially help with serviceability, it is not advisable to enter into IO arrangements for the sole purpose of obtaining a loan higher than you could otherwise afford.

Using a P&I strategy
P&I loans, as opposed to IO loans, can act as a forced method of savings. This may be particularly beneficial when your loan has a redraw option and you have access to any available funds in your loan account. 

As touched on earlier, the main benefit (especially with current low interest rates) is that making repayments off the principal can help you own the asset sooner. If repaying a non-income producing debt (e.g. your home loan) it is typically recommended that making principal repayments (and when able, repaying extra) is the way to achieve this. 

An exception can be made when a client advises us that they plan to convert their home to an investment property in the future. Here, a linked offset account helps manage the interest whilst making IO repayments. The balance in this account offsets that of the loan and therefore the interest no longer accrues on the full debt. 

This approach gets the best of both worlds by both managing interest cost while the property is the primary place of residence and preserving the ability to maximise investment benefits once it becomes an investment asset.

IO vs P&I 
The P&I vs IO strategy decision should be part of your wider borrowing strategy. Getting this decision right can be crucial in best positioning you to achieve your goals. Hopefully our advice has provided you with some tips to use for your own personal objective setting and financial situation. 

As always, we recommend you seek professional advice when planning your financial pathway.

Graham Turnbull is a financial strategist with Zinger Finance. 

Disclaimer: The views provided here are of a general nature only and should not be taken as financial advice. Please speak to a qualified professional before making any financial decision.

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