Interest Only or Principle + Interest

Real estate investing, even on a very small scale, remains a tried
and true means of building an individual's cash flow and wealth.
                                                                    - Robert Kiyosaki

This is a question I get asked a lot especially from first time property investors: should I go with interest only loans or principle + interest repayments from day 1? Most believed in the former; after all, the old adage "debt is bad" must be true right?

Well not quite, as Robert Kiyosaki puts it simply in his best seller "Rich dad poor dad", "Bad debt is bad, good debt is good"! Your mortgage investment loan is in fact a good debt, and it makes sense to hold on to the good debt for a longer period.

Wouldn't that cause you to have to pay more interest?

Yes. Unless if your loan has a linked offset facility.

Most people are pretty familiar with the functionality of an offset account by now. The balance of the offset account allows you to offset the principle loan amount, thereby reducing your interest repayments. So if you signed up for an Interest Only (IO) loan and leave the funds you would have otherwise used to repay the principle in the offset account, you are not actually paying a cent more in interest vs a Principle + Interest (P+I) loan.

So why is your mortgage loan a good debt and it makes sense to delay principle repayments with IO loans?

 

1. Flexibility

Offset accounts functions just like an everyday transaction account, you can make as many deposits or ATM withdraws as you like, the money you don't use is earning you upwards of 4% in tax free interest (depending on your mortgage interest rate). And if you do have ambitions to invest in another property, you have access to funds that can immediately be used on your next deposit. Because the purpose of that fund was to purchase an investment property, the interest repayments will be tax deductible.

 

2. Tax Benefits (negative gearing)

Interest repayments on loans against investment properties are tax deductible, so it makes sense to keep your principle loan limit as high as possible, to maximise deduction. Opting for P+I is counter-intuitive, therefore it is common to see property investors adopting IO loans.

But what about owner occupied lending, since there are no tax benefits there is no reason not to pay down debts right?

In principle: yes, in reality: often not the case. This is because our living arrangements change as we start different stages in life.  Twins on the way? Let's upsize to a 5 bedroom house. Retiring soon? Downsize to an apartment closer to the local hospital.

As we move from one property to another, our previously owner occupied property have now changed it's status to an investment property, thereby the interest repayments are now tax deductible.

Because of this status change, if you opted for P+I loan, you now have a less principle limit to deduct from. In fact, the more principle you had paid off earlier, the more you have reduced your potentially tax deductible debt.

100k of principle paid off for example, could easily make the difference of 2-3k in your tax bill. Maybe Robert Kiyosaki was onto something... not all debts are bad!

3. Inflation

The last point is a simple but often forgotten about principle. Australia's inflation rate in the last 10 years ranged between 1.5% to 5%. 

Your 500k mortgage loan today, is worth 500k, dollar to the dollar. However, over the life of the 30 year loan, 500k will not be worth nearly as much in 10-20 years time, inflation adjusted.

Banks price that into their calculations when they charge you a premium for your loan (even when the RBA cash rate is only at 2%). So why would you pay off more of your debt today, when the money is worth more, when you can delay payments till later, when inflation adjusted, it will be worth less.

Of course, the above is only applicable to those who can budget well and not spend beyond their means. If you are someone that cannot sit idol seeing money pile up in your bank account, P+I may be the way to go. Better yet, reconsider getting into mortgage debt in the first place!

I'll end by saying the article is only intended for general advice, please see a tax professional for qualified tax advice.