As financial planners we often asked what the difference is between Principal & Interest loans and Interest Only loans – otherwise known as P&I vs I/O loans. There are a great deal of explanations online to explain this, however it’s quite often that we see only half an explanation at a time. This article will introduce you to some of the reasons why you would choose an Interest Only (I/O) loan instead of Principal & Interest.
Why would I choose an Interest Only loan instead of Principal & Interest?
There are actually several reasons why you would want to just pay the interest on your loan rather than paying it down, however different methods are more appropriate for different people and different scenarios. Here are a few of the most common rules regarding how to manage your loan:
Cash Flow & Flexibility
Most people have heard the saying, “cash is king”. If you have any amount of debt, especially if it is substantial, you want to have the greatest amount of flexibility available to you. In this situation, being locked into constant high repayments can – in rare situations – be a massive burden to you. Imagine if something went a little bit wrong and you found yourself in a bit of a tight situation for a month or two (let’s say due to sickness or an unexpected large expense) your loan is going to really bite, especially if a reasonable proportion of your loan repayments are going towards paying off the loan as well as looking after the interest.
In this situation, if you were to have an interest only loan, you would be able to contact your bank, bring your monthly repayments back to just the interest while you are recovering and then put them back up to whatever you wanted them to once you feel that your cash flow can handle it. It’s very easy to do, and it gives you the breathing space to manage your affairs a lot better than if you were locked into more restrictive credit contracts.
Interest Only Loan Tax Reason #1
You have multiple reasons for wanting an Interest Only loan when it comes to tax. The first is again down to flexibility and is founded in the very foundation of tax law. The ATO is more interested in what you do with the money that you claim as deductable than where that money is from. So if you have an investment property, the fact that the money was used to buy that property is more important than the fact that you may have used your home as security to buy it. If you only have your home and no other borrowings, this will come into play if you decide to rent your property out in the future.
If you have an investment loan that is receiving Principal & Interest repayments, your debt is obviously going down. The great thing about this is that if you need to get your hands on some money, you’ve been building up a buffer by paying down you debt. The downside is that if you use any of that buffer to buy something that is not income generating (such as a car, holiday or renovation on your own home) then the interest that you have to pay on the money that pulled out is no longer tax deductable. Why is that? You’ve just borrowed money to buy something that is not income producing.
Had you been paying Interest Only on your loans, you could direct all your spare money to an offset account. An offset account is a normal bank account that a bank may give you which is linked to your loan account, but is not part of your loan account. Every dollar that you put in the offset account is a dollar that the bank will take off your debt when calculating how much interest you have to pay. As an example, if you owed $600,000 and have $200,000 in an offset account, the bank is only going to charge interest on $400,000, even though the loan balance is still actually $600,000. If you wanted to take out some of you savings and like before spend it on something that is not tax deductable (because it does not generate an income) then you’re not actually borrowing any money – you’re taking it out of your bank account. You’ll be paying more interest since you’ll have less in your offset account, but because you didn’t actually borrow the money, the ATO will deem the nature of the debt to still be for investment and you’ll be able to claim the lot of it as a deduction.
Interest Only Loan Tax Reason #2
The other reason is a matter of efficiency and value. If you are claiming the loan as being deductible, then you can assume that the ATO is effectively subsidising the cost of you debt. Using some basic numbers:
$100,000 loan @ 10% = $10,000 interest
If the loan was for investment purposes, then the $10,000 interest is tax deductable. If you’re on a marginal tax rate of 40%, when you do your tax return you’ll be entitle to get back $4,000 from the ATO. Therefore, the net amount of interest is:
$10,000 – $4,000 (tax return) = $6,000.
As a result of this, we can work out our after tax net rate of interest:
$6,000 (net interest) on a $100,000 debt = 6% after tax rate of interest.
Using this formula with today’s interest rates, if you’re paying your bank 6.5% interest on your loan, your after tax net rate of interest is actually 3.9%. That is pretty cheap money. Now ask yourself this – if someone lent you money at 3.9% – would you want to pay it back, or would you use what money you had to investment and aim for a higher net return? Depending on the level of risk you feel comfortable with, the answer might be very clear now as to what is the best thing for you to be doing. A lot of people say you should pay Interest Only your loans because it keeps your tax deductions high. Tax deduction is another word for expense that the Tax Act allows you to claim as an offset to income. Keeping your expenses as high as possible does not sound like the right way forward, does it? It’s similar to saying “I’ll chop my arm off, that way I don’t need to buy nail clippers” – well, that may be a little extreme.
You would want to pay Interest Only on your loan because – after tax – there may be more efficient things you could be doing with the money. However, it all comes down to what your long term priorities are and what type of risks you feel comfortable taking on.