Long Property

If there was ever a time where borrowers needed better advice and education… this is it.

We are in a residential lending market where bank policies and pricing are literally changing on a weekly basis.

Add to this slowing capital growth forecasts for Melbourne and Sydney, and it really is vital now that borrowers buy their properties and structure their finances correctly.

What I want to touch on today is the general lack of knowledge around the mechanics of Principal & Interest (P&I) loans, with offset accounts. This also then leads into to one of the most common questions I’m being asked today… “should I switch from Interest Only to P&I”?

It’s an important consideration because we’re in a market now where there’s a ~0.65% disparity between interest only rates vs. P&I rates (P&I being cheaper), and the disparity seems to be widening.

Here’s a snapshot of the key differences between the two repayment types:

* As at 1/8/2017 at the major banks new interest only investment lending is approximately 0.65% more expensive than P&I. Interest only repayments for owner occupiers is uncommon now, so the focus of this article is on investment lending.

In short, P&I interest rates are a lot cheaper in the current market, but they consume more cash flow, which goes towards reducing (‘amortising’) your debt.

Here’s what you need to know:

• If your P&I loan is fully offset (e.g. $500k loan / $500k offset), then you pay $0 interest, and therefore 100% of your repayments go towards reducing principal
• Paying your loan down in this manner results in ‘excess’ principal payments, and at St George (which is representative of how most banks work) these build up in what’s known as ‘redraw’, which means you can then re-draw these funds back out of the loan again if you ever want to
• By reducing your loan balance you create more equity in your property, this in turn increases your net worth and puts you in a more conservative leverage position
• the interest you pay on investment debt can be tax deductible, so by reducing investment debt you may also reduce your tax deductions (however with a P&I loan the majority of your repayments in the early years go towards paying interest anyway, so the effect on deductibility in the early years is relatively minor)

Also don’t feel that the switch to P&I locks you in for life. With a variable P&I loan you can apply to switch back to interest only at a later date with no fees involved (depending on which bank you’re with you can do this after 90, 180 or 360 days). You can also always apply for a top-up (e.g. more lending, which will arm you with more cash). This can easily be achieved if there’s a valid purpose and you can service the debt, however it may not be possible if your loan ratio is above 80%.

Here’s a mock example to give you a sense of the factors we consider when determining whether clients should switch from interest only (say with investment rates today at 5.05%) to P&I (say with investment rates today at 4.40%).

Assume you have a $500,000 investment debt, with $100,000 in offset, and this is securing a $625,000 investment property, generating $450/wk rent (3.75% yield).

Assuming a 39.5% tax rate, $0 depreciation, and 20% costs to run the investment (e.g. for property management, rates, insurance, maintenance etc.) the relevant calculations to help your decision making would be as follows:

• Interest savings in first 2 yrs with P&I is $6,278 (on average $3,139 savings p.a.)
• Repayments with P&I would go up by $821 per month ($9,852 p.a.)
• Cost to run investment Post-Tax with interest only is $895 p.a. (tax refund of $585)
• Cost to run investment Post-Tax with P&I is -$831 in the first year (e.g. due to the lower interest payments the property has turned from negatively geared into positively geared, you make $1,374 gross profit, tax paid on this profit is $543)
  • P&I structure results in $543 (tax you pay) + $585 (refund you don’t get) = $1,128 worse tax outcome in first year
• Cost saving is $895 (running cost interest only) + $831 (running profit P&I structure) = $1,726 to run the property on P&I rather than Interest Only

(*please note the above is only an example and you should seek tax advice that is appropriate to your situation. The above is not to be used as advice and you need to take into account your personal financial situation.)

So if you had the extra ~$10k p.a. cash or disposable income, and wanted to save at least $1,726 p.a., then switching to P&I would be a good move.

Another option would be to consider a cheaper Interest Only rate with one of the non-major banks. These are currently between 3.84% to 4.44% (vs. 5.0%+ at the majors), depending on whether or not you have equity in your home).

In summary, P&I loans require higher cash flow but can be effective in terms of paying less interest and reducing debt. There’s no one size fits all strategy as everyone’s circumstances are obviously different, but make sure your adviser properly explains your options to you, that way you can at least make the most informed decision.