Home loan products: P&I vs IO loans

When I was younger (I wasn’t the coolest kid) I used to wonder why anyone would take on a massive home loan and opt to pay off the interest only. When you take on a home loan, you can typically choose from P&I (principal & interest) and IO (interest only) products. Here’s what they mean and here are some of the things people think about when they’re considering which option is most suitable.

P&I loans

Most mortgage repayments are made up of two components: principal and interest. Interest payments are self-explanatory and principal means paying down the actual loan amount. When you take on a P&I home loan, you are agreeing to make both principal and interest repayments from the day you first draw down on the loan. Let’s work through an example. After a year of weekly housing inspections, you finally decide to pull the trigger on a $1.2m prison cell-sized studio apartment on the north shore suburbs of Sydney. You come to the table armed with a $200k deposit and the bank has agreed to extend to you a $1m loan to make up the balance. With an annual interest rate of ~2.50%, you’re looking at monthly P&I payments of around $3,950 before fees. Just over half this monthly repayment is interest alone.

The key characteristic of a P&I loan is that slowly but surely, you’re paying off the actual loan amount (the principal). The interest that accrues on your loan goes down over time as principal is paid off. A P&I loan is pretty much the most vanilla home loan out there. It’s not particularly exciting but it’s generally the cheapest.

IO loans

IO loans are more popular among residential investors rather than owner-occupiers. IO loans are generally more expensive in that the interest rate charged is often higher or there may be higher fees associated with the loan. IO loans are also more expensive in the sense that the longer you put off paying down the principal, the more interest you’ll pay overall on your loan. It all sounds pretty bad so far hey? So why would anyone opt for an IO loan? Two main reasons:

  1. Avoiding paying principal in the interim means more cash-in-hand in the short-run.
  2. Seek your own advice but generally-speaking there are certain tax advantages to IO loans.

Having more cash-in-hand means you’ll have more money readily-available to invest, to help manage your personal finances or if you really, really want to tell the whole world you’re all kinds of #basic, to splurge on a new pair of birkenstock sandals. Property investors, especially those who may have a few properties in their portfolios, have big ongoing mortgage repayments and having extra cash-in-hand can be a very useful risk hedge against future rainy days – for example a number of your properties unexpectedly sitting vacant for an extended period of time as a result of idk a pandemic or something.

Let’s continue with our prison cell (sorry apartment*) example above. Say you went to the bank and borrowed the same $1m with a 200k deposit but this time you opted for an IO loan. The bank says fine but you’ll have to cop a 3.00% interest rate because we’re [insert dysphemism for phalluses]. Here you’re looking at a monthly repayment of around $2,500 before fees. You’re paying more in interest and you’re not making a dent on the loan principal but you have almost an extra $1,500 in your pocket every month. Just FYI the bank is likely going to be unwilling to extend an IO loan to you forever as that position comes with a fair degree of risk for both the bank and yourself. The IO loan will likely convert to a P&I loan at some stage (always read the T&Cs).

Debt recycling

We’re going to finish off this article by delving into a fair bit of tax strategy. All of the below is qualified with “pls seek your own tax advice as your circumstances might differ and the below is for general knowledge only thx”.

If you think for a second that high income earners are forking out 45 cents on the dollar for most of the dollars they’re earning, you’d be gravely mistaken. High income earners often invest in assets which tend to pay off in the long run but offer handsome tax deductions in the interim. Property can be one such asset. A very common practice among property investors is this concept of debt recycling. The idea is that if you have multiple streams of debt, you want to minimise as much of your non-tax-deductible debt as possible and maximise your tax-deductible debt. There are obviously exceptions to this such as credit card debt (please don’t hold credit card debt). Let’s work through an example.

Say Kat had made some pretty wise decisions in her youth and by the age of 35 she has an investment property under her belt and she’s also purchased her own home. It would make very little sense for her to have a huge mortgage on her home but a tiny mortgage on her investment property. Why? Well she can’t deduct interest she pays on her owner-occupier home loan from her taxable income but she can deduct interest she pays on her investment property from her taxable income. So ideally, she’ll want to have paid down as much of her owner-occupier home loan as possible and have taken on as much debt as possible on her investment property.

Be very, very careful with debt recycling. There’s a very complex, very stupid quirk in the Australian tax code that hurts you if you recycle debt under certain circumstances. The quirk goes like this. Say Kat had been making P&I payments on her investment property for a few years before she purchased her own home. She had started with a loan of 800k and by the time she was ready to buy her own home she had 700k in principal remaining.

Say the bank was willing to let Kat borrow back this paid-down principal (100k) to use as a deposit towards her home. Well the tax code says that if you withdraw paid-down principal for a non-investment purpose, you’re no longer allowed to deduct the full amount of tax-deductible interest you pay on your investment property loan. So come tax time, Kat will only be able to claim interest payments she makes on 700k worth of loan dollars despite the fact she has an 800k loan on her investment property because she used the 100k for a non-investment purpose (ie as a deposit on an owner-occupier, non-tax-deductible home loan).

What’s the solution? Well if you’ve been paying attention you will have noticed by now that IO loans on investment properties don’t come with this problem. Why? Because you’re not actually paying down any of the principal. There’s also another solution if you don’t quite fancy IO loans which we’ll take a look at soon when we explore redraw facilities and offset accounts.