Principles of interest
I HAVE written before about the challenges that can arise from the banks’ recent practice of moving borrowers from interest-only (IO) loans to principal and interest (P&I) loans on investments.
While it may be possible in some cases to maintain the status quo by changing banks, or by doing some robust negotiation, these options are not available to everyone.
So, let’s think about ways we can turn that lemon into lemonade. The key here is that IO loans are currently priced about 50 basis points higher than a P&I loan, so by moving to P&I you are saving interest.
Assume you have an investment loan for $400,000 on an interest-only basis at 5.5 per cent. The monthly repayments would be $1833, wholly taxdeductible, and at the end of the term you would still owe $400,000. Now, let’s suppose the bank nudged you into a P&I loan over 30 years at 5 per cent for that $400,000. Your repayments would rise to $2147 a month, consisting of $1667 of interest and $480 of principal.
The good news is, you are saving interest; the bad news is you are gradually losing part of the tax deductibility.
However, even though interest is tax-deductible, wouldn’t you rather be paying $1667 interest a month than $1833?
Most investors are in the 34.5 per cent tax bracket when Medicare is included. This means you are paying 65.5 per cent of the interest, while the government is paying just 34.5 per cent of it.
Some investors complain that falling interest rates mean they lose tax deductibility.
I always offer to refinance the loan for them at 25 per cent — this would really maximise their tax deductions — but I haven’t had a taker yet.
Now, let’s fast forward 10 years. If interest rates remain unchanged, the IO borrower will still owe $400,000, while the P&I borrower will have reduced their loan to $325,000.
The P&I borrower has made a hefty reduction in the principal, and created a big safety buffer if interest rates rise.
Now, let’s refresh our knowledge of why interestonly loans, or very long-term loans, are best in certain circumstances. If you have a loan on your residence, as well as an investment loan, it’s a nobrainer to have the investment loan on the longest term possible so as to maximise the amount of money you have available to quickly pay off that home loan. If you can’t get an IO loan, go for a 30-year one.
Another common situation is when a person aged 55 or more still has a home loan, which they hope to have paid out by age 65 when they retire.
Repayments can be crippling on a P&I loan that has only a 10-year term. A better option would be to leave the home loan on the longest term possible, and maximise the amount contributed to superannuation via salary sacrifice.
This turbo-charges the super, with the aim to withdraw a lump sum at retirement to pay out the home loan.
Continually changing rules mean that managing your money is not a case of set and forget. Noel Whittaker is the author of Making Money Made Simple. His advice is general in nature and readers should seek their own professional advice before making financial decisions.