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Mortgage Mindset: IO vs P&I

Should you pay down debt using principal and interest, or boost your cashflow with interest only? Peter Norris considers your options.

18 January 2023

Should you pay interest only on your lending or should you pay principal and interest? Cashflow investors and long-term growth investors have been having this argument for decades.

Property experts debate this furiously while I sit on the fence. My view is that the most tax in-efficient debt should be on principal and interest (P&I), leaving the more efficient debt – the tax-deductible debt – on interest only. Generally speaking, if you have lending on your own home then you would have that on P&I and your investment properties would be on interest only.

Recent tax changes have shifted this slightly, given that borrowing against existing investment properties is now also inefficient.

The comparison between interest only and principal and interest is one that usually only occurs for property investors. Banks these days are hugely reluctant to put debt that is secured by your owner-occupied home on interest only. Even the alternative lenders don’t like it. This is because they want to see you getting that debt against your home gone and ensure that you aren’t left with a big mortgage when you retire. I’m in complete agreement with this.

The exception to this rule is when you’re building a new owner-occupied home. Generally, you’d keep your loan payments on interest only during the build to mitigate cashflow issues if you are renting or paying an existing mortgage at the same time. Once the build is finished though, the bank will move you back to P&I.

For investors, the debate is less clear-cut.

So, what are the differences?

Interest only

This is pretty straightforward. Interest only is where you pay only the interest amount each month and make no principal reduction. With the main banks, the interest only terms can be for a maximum of five years. At the end of that term, your loan balance will be the same as when it started. Interest only payments typically have to be paid monthly.

Principal and Interest (P&I)

This again is pretty straightforward. P&I is where you make a set repayment every week, fortnight or month. Interest is calculated daily – based on the balancing owing – and charged monthly. Because of this, paying weekly or fortnightly will save you interest in the long run and help you pay the lending off faster.

With P&I, you have a minimum repayment which is determined by your loan term, for example, 30 years. In the early days, your payment is weighted heavily towards interest rather than principal, so it can feel like the loan isn’t going down. It takes roughly 15 years before the weighting shifts in favour of principal! However, there are ways you can structure your lending to ensure you get ahead and get that loan paid down faster. For example, you can increase your minimum payment slightly, or make additional lump sum payments. Or, you can use a revolving credit facility to minimise the interest you’re paying.

How can it affect your borrowing?

What doesn’t get talked about a lot is the impact that interest only has on your borrowing ability. Believe it or not, having your lending on interest only will decrease the amount you can borrow! This is because it reduces the term that the bank tests your affordability against.

For example, in almost all cases, when you apply for lending, the bank will test your affordability over a 30-year P&I term, using their test rate – which is currently around 7.85 per cent. However, if you want to put that lending on interest only for five years, then the bank will test your affordability using the term remaining after your interest only period finishes (25 years). Using the bank’s test rate, a $500,000 loan would cost $3616 per month over 30 years, whereas over 25 years that loan would cost $3809 per month. Therefore, you need to demonstrate a higher level of servicing to get that same loan on interest only.

As an investor, understanding how this works can help you in your quest to borrow more. You could remove the interest only term altogether, or you could reduce it down to two or three years. In this case, you’d need to understand that, when that term is up, you need to re-apply for interest only or move onto P&I.

Like I said at the start, interest only versus P&I is a long-standing debate. Regardless of this, structuring your lending to suit your personal situation is important, and having a mortgage advisor who understands what you’re trying to achieve is essential.

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