Conventional wisdom is wrong - P&I vs IO
Conventional wisdom states that investment debt should almost always be Interest Only (as opposed to Principal and Interest). The reasoning? Maximise deductible interest and redirect the cashflow savings to pay down your non-deductible home loan.
However, I’d argue this conventional wisdom is a relic of when IO and P&I rates were the same/similar. Nowadays, it’s more complex and P&I is better in most cases.
But many in the industry continue to push this strategy without crunching the numbers. As a financial adviser, I'm often met with resistance when I suggest considering P&I to a client’s mortgage broker.
So I decided to run the numbers. I modelled 6 scenarios to show when P&I or IO makes the most sense.
Find the comparison here - https://docs.google.com/spreadsheets/d/e/2PACX-1vQQ1oebdTAop2QFKz4xq-tXiA7BiHmpyPb1X3jW1rX-vLkbtG7LGrpme2hD42Ie0kX-nOh5DbZEHGIl/pubhtml
I've run 6 scenarios and the "winner" and trend can be seen in the image below. Red represents the year in which IO becomes more favourable. However, if you’ve already repaid your home loan by that particular year, you’ll never reach that point and P&I will be more favourable.
Key Findings
1. Base Scenario
- Assumptions: $500k bad debt, $100k good debt, 39% marginal tax rate, refinancing P&I every 4 years to reset the term.
- Result: IO only catches up with P&I in year 27, and that’s after redirecting the tax refund (from higher IO interest) to the home loan. However, many borrowers have fully repaid their loan before year 27. Thus, P&I is usually better than IO.
2. Higher Marginal Tax Rate (47%)
- A higher marginal tax rate reduces the time it takes IO to “overtake” P&I, but the breakeven still isn’t until year 18. The opposite trend would occur if your marginal tax rate is lower than 39% in that the breakeven point would be later.
- Depending on the time until you expect to repay your mortgage, IO could be more of a consideration if you have a higher MTR.
3. Lower Interest Rates
- Counterintuitively, lower rates favor P&I. While IO frees up more cashflow for non-deductible debt (below), the relative cost of the investment loan loading is bigger.
4. Smaller Rate Loading
- As you would expect, if we lower the loading to 0.2%, IO becomes more favourable and the breakeven point is after 10 years (instead of 27).
5. No Refinancing
- If you never refinance the P&I loan to extend its term, IO only becomes favourable after 19 years, proving that regular refinancing significantly improves P&I outcomes.
6. Larger Investment Loan ($300k good debt)
- If the investment loan is larger relative to your home loan, IO is never justified over 30 years because of the higher interest costs. The opposite trend would occur if the deductible debt is reduced (e.g. from $100k to $50k in this instance) in that the breakeven point would be brought forward.
Happy to answer any questions or discuss feedback!
TLDR: Don’t choose IO automatically. Nowadays, P&I is often better than IO, so run the numbers based on your specific circumstances.
Cheers,
Kyle