Interest Only Loans

I have a package with one of the big four banks. We have IO equity lines of credit for our investment properties and a P&I loan for the family home.

I want to minimise the loan payments on my IP’s and maximise the payments on my non tax-effective home mortgage (so I can get more equity, etc). We have all our IO LOCs at just under 6% and we have no monthly account keeping fees for any of the loans. Once I have paid off the home mortgage, I will redirect the cashflow towards my investment properties (if prices are bad and it’s not worth buying), or if the market is good for buyers, look for another IP to buy.

I have no intention of selling any of my properties and our lines of credit are good for some 25 years. So, when I have to “payout” the LOC’s, I will be paying out the same dollar amount that I was originally charged way back in 1999, using today’s dollars! Not bad when you think about it – plus I claimed tax relief on all that interest.

I am reasonably confident that the properties would have appreciated in value over that 25 year period and I am comfortable with my current LVR’s.[]

Cheers,

Rowan

Rentmaster,

Thanks for posting those figures (I was quite shocked to see the P&I repayment – until I realised you were paying off the loan in 10 years).

Assume you have a 200,000 loan, for 10 years at 7%
For interest only…
per month pay 1166
total interest paid = 140,000
total payments = 340,000

P and I….
per month pay 2322
Total interest paid = 78,000
Total payments = 278,000

Well, that certainly helps me to choose my direction. I’ll take the IO thanks, for the price of one. Own two similar IP’s with two similar rents coming in, put any “extra” into an Offset account to effectively reduce the Interest paid – then choose whether to buy a third or not. If not, I can pay down/out the loans using the “extra”.

But, at least, I won’t be having the Bank telling me I MUST pay $2300 per month (with only one rent coming in). It will allow me to choose just how much I pay off the mortgages.

Who wants to own them anyway? Isn’t controlling them more important?

Benny

Wow J!! I get the idea. You make a good point.

The original numbers are very theoretical and only really points to the idea that over time interest only costs you more in interest and total costs, whereas P and I costs less in total. My numbers are by no means a conclusive comparison. There are all sorts of what if scenarios you could use to alter things.

In reality you are not likely to take out a P and I loan over 10 years. It is more likely to be 25 years. Also if you are like me you get to make lump sum payments which shortens the term and pays it off quicker.

The other thing I like about P and I is that if you pay off lump sums you increase your equity in the property which you can then use as collateral towards your next property while at the same time saving total interest. If all you pay off is interest, then when it comes to getting your next property, you either need a cash deposit or rely on capital gains in other properties.

Is you top tax rate really 48.5%? In NZ the top rate is only 39%. 48.5% makes interest only a more interesting proposition because of the increased returns.

Andrew
http://www.rentmaster.co.nz
Software for Landlords

I for one would be interested to see the formulas you used.

In NZ the top tax rate kicks in at $60,000.

Andrew
http://www.rentmaster.co.nz
Software for Landlords

quote:

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The biggest advantage of Interest Only, is the increased cash flow. Quite simply, it could mean the differrence betweenbeing positively gearedor negatively geared. Remember, if you are positively geared, there is no limit to the number of properties you can buy.

Dan.

If you want an extraordinary life you have to be prepared to do things that ordinary people aren’t prepared to do.

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I think the banks think they will be positivly
geared and also calculate an annual property
suburb growth rate so that they can justify the
lending amount. Hope that helps Kierra. Welcome
to the Forum. a Sydney-sider or a Melbourne-er?

Hi Andrew (and other forumites),

Like Kierra, I’m a newbie on the forum and in just 2 days I have read a lot of valuable insights and confirmed some of my own theories!

Although I have been in the IP game for a few years, (yeah I know, get some time up!!) this is a good forum that has a strong focus on positive cashflow and its inherant benefits.

Keep up the good work everyone – we are all reading and learning!

Doogs – I too would be very interested to check out your formulas. I enjoyed your post that covered the present worth of borrowing PI versus IO loans…

Cheers,

Rowan

Hi everyone, here are my promised formulas. Sorry it’s a bit long winded. They mightn’t be strictly accurate from a purist economist point of view, but I’m sure they are a reasonable approximation. Hopefully I haven’t miscued the calculator again.

Define the following variables:
A = repayment Amount per compounding period
P = Present worth
F = Future worth
R = Residual amount owing after n periods if A is not enough to pay off P in that time.
r = interest per compounding period (usually interest pa/12) (interest is expressed as a ratio, not a percentage, eg in the example above, r = 0.07/12 = .00583333
The term (1+r) to the power n occurs often so I’ll call it “Q” to tidy up the formulas, ie Q = (1+r) to the nth power. (I can’t do superscripts)
I’ll use * as a multiply sign and / as a divide sign.

Formulas used:

Capital Recovery Factor {A/P} = (r*Q)/(Q-1) ; multiply this by P to get the monthly repayment amount needed to pay off P after n compounding periods.

Single Payment Present Worth Factor {P/F} = 1/Q ; The present worth of a single future payment F in n compounding period’s time.

Number of periods required to pay off the principal P with a payment A and interest r per period is given by reverse engineering {A/P} to extract n as follows:
n = LOG(1+r/[A/P – r])/LOG(1+r) ; The LOG function is to base 10 or natural log, it doesn’t matter, so long as you use the same for both.

The amount of loan still owing R after n periods if A is too small to pay off the principal P is given by R = Q*[P – A*(Q-1)/(r*Q)]

Applying these to the example:
P = $200,000, r = .07/12, n = 120 gives: {A/P} = .0116108, so A = (200k * {A/P}) = $2322.17 as shown in RentMaster’s P&I example. This will pay off the loan in 10 years, ie n = 120 months.

Finding the present worth of these payments is basically a reversal of this formula, but using the inflation rate r = .035/12 (assuming a nominal inflation rate of 3.5% pa). Above, P was the initial loan principal, so I’ll call the real present worth of the repayments with inflation taken into account as P(real). So {A/P} now is .00988859 which gives P(real) = $2322/{A/P} = $234816.

Similarly P1(real) of A = $1166 for the I/O loan is $1166/{A/P} = $117913
P2(real) of the future payment F of 200k in 120 months time is given by P2(real) = 200k*{P/F} = $141009 (for r = .035/12).
Now total P(real) = P1(real) + P2(real) = $258922

To find the effect with tax at 48.5%, firstly interest only is easy, as each payment is purely interest, and identical, so the net payment per month after tax refund is 0.515 * 1166 = $600.49 (Note that I’ve simplified the tax refund by assuming it is paid monthly, but this will be a reasonable assumption if you have put in a “withholding variation” to the ATO, ie you can get your tax reduced if you are negatively geared, so your fortnightly pay is correspondingly higher.) The P1(real) is now $600.49/{A/P} = $60726, which added to the same P2(real) above gives total P(real) after tax effect for I/O = $201,735.

To find the tax effect on P&I, I only know how to do uniform series, ie where A is always the same. In reality, most of your early payments are interest, and most of the final payments are principal, so you get more tax refund at the start then at the end. After the tax refund “each month” you effectively pay a smaller net amount per month. The net payment increases as the loan diminishes. Eg, at the end of period 1, interest payable = .07/12 * 200k = $1166, reduced by refund to 0.515*1166 = $600.49. At the end of period 60 (half way in time), residual R = q*[P – A*(q-1)/(r*q)] where q = (1+r) to the 60th power, ie R = $117286 which is the amount of principal still owing. Interest on this amount in the 61st period would be $684, which after tax refund would be $352.
To simplify the maths, I assumed the tax refund would be used to pay off principal (or sit in an offset account which give the same result). This would be equivalent to a P&I loan with an interest rate equal to .07*.515 or .03605 (3.605%). The loan would be paid off earlier if this were the case, and to calculate the reduced n:
n = LOG(1+r/[A/P – r])/LOG(1+r) The A/P terms refer to the actual payment per period divided by the principal, which is 2322/200000 = .01161 and r = .03605/12 which results in n = 99.82, so assume n = 100.
Now P(real) of the 100 payments of $2322 is $201150, calculated as before, with r = .035/12.

Hope all that makes sense. I’ve shortcutted some of the detail, as it is long enough already.

Jim. (about to jump into my fox hole to dodge the bullets from real economists![])

Hi, Wizard home loans also do 10 year interest only terms, maybe you pay for the privilage in the interest rate (6.22%). We are just newbies with little knowledge and didn’t think this was too high. We took the 10 years to give us plenty time to make decisions about our strategy. Sure getting the gist of things from this forum – thanks, Sparky