Interest Only? Or Principal and Interest?
21 March 2017
INTEREST ONLY? OR PRINCIPAL AND INTEREST?
This is a question that gets asked again and again in property circles, with a few different opinions.
In my opinion, the reason to own rental properties long term is to receive passive income. Unfortunately, a lot of rentals run at a cash loss due to high interest costs. But if the loan is slowly repaid and the interest costs slowly decreased, the rental can change to being positive cash flow and providing passive income. This is a very safe method of becoming cash flow positive as you are not reliant on rent increases or lower interest rates.
So the main reason I go Principal and Interest (P&I) is to long term hold a debt free rental property providing passive income.
But ....... the "tax benefits"
A lot of experts and investors will argue "it's better to be on interest only, and to repay your personal home first, where there are no tax benefits". In a very simple sense, this is true. But:
- Is a tax refund really that great? For high income property investors, you are paying $3 to the bank to get $1 back in tax benefit. So really you are losing $2! Wouldn't it be better to not pay the $3!
- How much tax are you really saving? Based on a $500,000 rental, 36 year term and 5% interest rate, I compared P&I with Interest Only over the first five years. In simple terms, you would be paying $2,684 per month on P&I versus $2,083 on Interest Only. An extra $601 per month. Over five years you have repaid $36,000 approximately, plus saved $4,400 in interest (as you are paying interest on a lower loan). At 33% tax rate, this would have saved $1,462 in tax or $292 per year approximately over the five years. Is it really worth it?
- What would happen to the money if you weren't P&I? Most people find that money comes in, and the same money goes out. If you increase the amount coming in, it still disappears. If you increase the amount going out, you manage your money a little better and still survive. So, paying Principal forces you to be a bit smarter with your money, and if you weren't doing Principal repayments, you would probably find this money just disappears on something else.
The second reason I like P&I is because it builds a buffer without relying on capital gains. If you buy a rental for $500,000, pay P&I for five years, then you should only owe $460,000 approximately. So, if in a worst case scenario you were forced to sell, after commission and other costs, hopefully you could repay the $460,000 loan. Whereas, in a flat market, with interest only, the net sale proceeds might be less than the loan!
Where Interest Only can be appropriate
If you don’t have the cashflow to pay P&I , then you really have no option. You are effectively gambling that long term the property will go up in value and be more than your loan.
I hope you found this useful and that it has given you something further to consider.
Kind regards
Ross Barnett
