One of the key components for understanding structuring the finance for an investment portfolio is to understand the difference between interest only and principal and interest repayments for your loans. Choosing the right repayment type will be fundamental to ensuring you have the most efficient finance setup, to maximise your borrowing capacity, reduce personal debt at an accelerated rate and ensure you’re receiving the most tax benefits possible.
What exactly is the difference between interest only and principal and interest?
Interest Only (IO)
- Repayments are set at only paying the interest accrued per repayment (generally monthly for interest only)
- No principal is paid down, so the loan stays at the same balance during the entirety of the interest only period
- Interest only is set for a specific period – generally up to 5 years (however some lenders will allow you to set it for 10-15 years).
- When the interest only period comes up for expiry, it can either be rolled over into a further interest only period, or may require an internal refinance to extend the interest only for a further 5+ years
Principal and Interest (P&I)
- Repayments are set to pay both the interest accrued and a portion of the principal (can be set as weekly, fortnightly or monthly repayment frequency)
- As the repayments exceed the minimum interest charge, the loan balance reduces each repayment by a nominal amount
But paying debt down is always good, right?
We’re always taught to pay down debt as soon as possible, and generally it is certainly a good idea. However in reality there are some important considerations – especially with investments where taxation also needs to be considered. By utilising the correct structuring – including repayment setups, you can effectively reduce your interest liability in the most efficient way possible, saving you money and maximise tax benefits.
So what is the best option?
Unfortunately like most things in life – there is no single answer when it comes to structuring your loans. More often than not, an interest only loan with an offset account will provide the greatest amount of flexibility in most scenarios.
How does IO help?
By setting up your loans as interest only, the minimum interest repayment is only charged, allowing you to redirect any excess funds to the most appropriate loan OR offset account. This can allow the investor to choose to redirect the funds into their PPOR loan as accelerated repayments, the PPOR’s offset account or in the case of no personal debt, into the offset account/loan account of the highest interest rate mortgage in the portfolio.
Here’s an example:
Bill owns a PPOR and 3 investment properties.
Each investment property interest only repayment is $200 per week, the equivalent principal and interest repayments would be $250 per week. Instead of paying each loan down $50wk under P&I, he instead puts each loan on IO, and with the excess funds he pays down his PPOR by a further $150 per week ($7,800 per annum). This means he’s reducing his PPOR loan down at an accelerated rate, which can also free up equity for future investment equity releases.
Alternatively Bill might be considering to rent out his current residence in the future and will need a deposit for his next home, he instead would put those extra $150 per week into his PPOR’s offset account, increasingly reducing the interest he pays on his PPOR and building a deposit for the next home. When the time comes, Bill can access his cash savings as a deposit to purchase his next home, whilst claiming the fully tax deductibility of the home loan on his ex-PPOR.
- Even if the property is a PPOR, it may be productive to put the loan as interest only. The main reason to do this would be if there’s a possibility that the PPOR will be converted into an investment property in the future
- Should you have no personal debts (home loan, personal loans, car loans, credit card debt) and you’re not likely looking to upgrade your PPOR in the future, it may be beneficial to switch some investment debt to P&I, as a forced savings regime. This comes down to personal preference as the same results can be achieved with IO, but can still be a valid part of a consolidation phase when an investor may be looking to reduce their debt exposure and in turn increase their cash flow by reducing their interest repayments
- Interest Only isn’t for everyone – it does require self-restraint and focus, as it will involve accumulating large amounts of funds within offset accounts. If you cannot trust yourself not to spend the funds when available, P&I may be a more suitable repayment type.
How do I make sure I’ve setup my finances to work best for me?
Talk to an investment focused finance strategist who can review your current setup and be able to advise you on how to structure your finances for cost saving, efficiency and to enable you to continue to grow your portfolio.
If you would like to have a discussion about your lending structure and the options available to you, click here to connect with us today