When rates are low, paying Principal & Interest (P&I) makes sense as it allows for faster loan repayments. Although, there are instances when Interest Only (IO) can be the better strategy to adopt.
How do IO and P&I work? Is it better to adopt IO or P&I repayments on your loan?
Interest Only (IO)
With Interest Only repayments, you’re only required to repay the interest portion + any fees on the loan over the IO period offered by the lender.
If you want to, upon expiry of the original IO period (usually 1–10 years), you must request and negotiate a new IO term. Before it comes around, ask what your lender allows at the IO term’s end.
The IO strategy
Assuming a property asset of a mortgage is going to increase in value is one of the reasons IO loans are popular. Some people use the tax deductibility of interest on their loan to maximise their interest repayments.
By freeing up the principal component of repayments, IO can offer cash flow benefits. Others take the opportunity to pay off other non-deductible personal debts — personal loans, car loans, or credit card debt — usually on higher interest rates.
IO can also offer prepayment of interest for the upcoming financial year. This may allow claim of the next financial year’s benefits in the recent one.
With most IO arrangements, many lenders allow flexibility to make extra repayments. Principal reductions can still be made when IO is being used as a way of reducing loan repayment amounts.
Disadvantages of IO strategy
IO arrangement is not advisable for the purpose of obtaining a higher loan amount. The repayments can result to a much tighter budget or inability to pay if an IO loan converts to P&I — especially during increases in living expenses or interest rate during the IO period.
With the remaining loan term, lenders will assess your serviceability at the end of an IO period. Say, on a 30-year loan and coming off a 5-year IO term, this will leave you repaying your debt based on the remaining 25-year term.
You should demonstrate your ability to repay the outstanding loan balance, which will accelerate for any extended IO periods. If you’re planning to, lenders won’t rely on any intended asset sale to repay the debt.
Another disadvantage of the IO strategy is overexposure should your property’s value fall, ending up with negative equity in your property.
Principal & Interest (P&I)
Principal & Interest loans are designed to be repaid over a defined loan term (usually 30 years). The lender calculates your repayments, including the interest charged for the repayment period, any loan fees, and a portion of the principal balance.
As your loan balance reduces under P&I, so does the interest component, assuming the interest rate is constant. This is if your scheduled repayment pays off more of the loan principal as you proceed.
The P&I strategy
P&I loans can be a forced method of savings. This is good if you have an option to access (redraw) any available funds in your loan account.
Let’s take a mortgage as an example. The main benefit is that making repayments off the principal can help you own the asset sooner.
If you’re repaying a non-income producing debt, it’s recommended to make principal repayments you’re priority. If you can, it’s better to also pay extra.
An exception can be made if you plan to convert the asset to an investment property. A linked offset account will help manage the interest whilst making IO repayments. The balance in this account will offset that of the loan and the interest will no longer accrue on the full debt.
