Yesterday I had a lengthy debate with my friend.
The question that always come up when a property investor wants to buy an investment property:
Should he get an Interest Only loan, or pay the Principal & the Interest?
My friend and I had a fight. We couldn’t agree on what to do. He is confident that it’s better to pay Interest Only. On the other hand, I’m not so sure…
Let me give you some arguments against paying Interest Only, and some arguments for choosing Interest Only.
ARGUMENTS AGAINST INTEREST ONLY:
- You pay a higher interest rate.
Investment loan interest rates at the moment start from around 2.3%.
If you want to pay Interest Only, the rates start from around 2.5%.
So it is around 0.2% more expensive. - You pay a higher interest rate on the whole mortgage balance.
My argument against my friend, who wanted to pay Interest Only, is that he will need to pay the higher interest rate, let’s call it 2.5%, on the whole mortgage balance. So if he has a $1m mortgage, his interest charges in the first year will add up to $25k.
If he has a Principal & Interest loan, his interest charges in the first year will be under $23k, that’s 2.3% multipled by the $1m mortgage balance. For simplicity, we ignore the reduction in principal each month.
If you go to the mortgage repayment calculator on the MoneySmart website, you’ll find that the repayment on a $1m mortgage at 2.3% interest rate is $3848 per month, of Principal & Interest.
If he pays Interest Only, each month he pays $2083, based on the higher interest rate.
So each month, he pays $1765 less, and this equates to around $21k for the first year.
So, he pays $2k more in interest charges, to have an extra cash flow of $21k in the first year.
For this to make sense to him, in my mind I was thinking, he would need to be able to invest the $21k, and earn a guaranteed rate of return of 9.5%. He needs to be very sure that he’ll get more than $2k worth of investment income, if he has an extra $21k of cash flow.
I was thinking, no way, that kind of return is not 100% guaranteed. He’s better off paying Principal & Interest towards his mortgage, pay $2k less interest, and lose his $21k worth of cash flow. This is a guaranteed savings, versus non-guaranteed investment return. - You still pay more interest charges after offsetting the additional tax deduction.
A commonly cited reason for paying Interest Only is that you get to claim more tax deductions.
I’m not a big fan of paying more interest to reduce taxes.
When you choose an Interest Only mortgage, your interest charges become bigger, so you claim a bigger deduction in your tax return.
But the value of the extra tax deduction is never higher than the amount of additional interest charges. So you still pay more. It’s less of more, but it’s still more, more interest charges, even after netting them off against the additional tax deduction.
In the example previously mentioned, you claim an extra $2k of tax deduction. The extra out of pocket expense will be $1400 if your marginal tax rate is 30%. It’s still money out of your pocket, so I consider this to be an argument against paying Interest Only. - You take on more risks.
Bigger risks often come with bigger rewards. But you’re still taking on risks.
If you don’t pay down your principal, you don’t build up equity in the property. You’ll have extra cash which you may end up investing into risky investments, such as the share market, Bitcoin, Dogecoin, or even Pancake Bunny. If those investments don’t perform well, you may lose your money, and you don’t have equity in your property. So you may be left with nothing. - You reduce your borrowing power.
It’s funny, but if you have a 5-year Interest Only loan, the remaining term on your mortgage will be 25 years.
So you only have 25 years to pay down the principal. For the same set of income and expenses, the bank actually gives you a smaller maximum loan amount if you choose an Interest Only loan. It could be something like 10% less. So the property you buy may need to be around 10% cheaper. This means you have less to leverage. Less leverage generally means smaller return on your cash.
ARGUMENTS FOR INTEREST ONLY:
- You get to keep more of your cash for other investments or for your business.
When I had that debate with my friend, I forgot that the $2k or $1400 after-tax savings I mentioned before, only happens one time, in the first year. In the second year, he still will not have the $21k worth of extra cash flow, but he will not get another $2k worth of savings. He does get around $2k worth of savings in the second year, but this should be attributed to the extra $21k worth of cash flow he would have to further sacrifice in the second year. - You get to keep more of your cash for a few years until you sell your property or ask for a cash-out.
Now, my friend is saying, as long as he can invest his money and get more than the interest rate, of 2.5%, he’s better off choosing an Interest Only mortgage.
I believe this argument is only valid if he never ever sells his property.
From what I can see (and please let me know if I’m wrong), if he does sell his property in let’s say 5 years, he would get all his cash back into his pocket. He does not lose his cash flow forever.
In the example above, the monthly repayment on a $1m Principal & Interest mortgage at 2.3% interest rate is $3848 per month (around $46k for 1 year). The interest charges for the first year is 2.3% x $1m = around $23k. Hence the principal paid down in year 1 is $46k – $23k = $23k. Ignoring the fact that the loan is progressively paid down each year, he would get around 5 x $23k = $115k when he sells his property after 5 years.
Each year, he would have lost around $21k of cash flow.
If we use the Excel formula =RATE(5, 21000, 0, -115000), we get around 4.6% per annum. I argue that this is the relevant benchmark rate if return which my friend needs to compare against, for him to choose an Interest Only loan rather than a Principal & Interest loan, if he believes he’ll sell the property within 5 years. Further, this 4.6% rate of return must be a guaranteed rate of return.
In practice, as the years go by, the additional interest charges (from choosing an Interest Only strategy) becomes bigger each year, as the Interest Only loan is not progressively paid down like the Principal & Interest loan. Another way to say this is, the principal obtainable at the end of 5 years will be around $123k instead of $115k. On the other hand, the loss of cash flow remains the same, at $21k each year, because his contractual monthly repayment on the Principal & Interest loan is set at the start of the loan. The benchmark rate of return is closer to 5.9% if we account for the monthly reduction in principal over time.
So if his investment return is under 5.9%, he would be better off choosing a Principal & Interest loan. This way, he only needs to pay an interest rate of 2.3%, on the whole loan balance of around $1m, and save $2k+ each year in interest charges.
Most people either sell their property within 5 years, or refinance and ask for a loan top-up within 5 years. So, even though it makes sense to choose an Interest Only loan to keep more of your cash flow, you do need to forecast when you expect to sell the property or ask for a loan top-up, use this time horizon to determine your benchmark rate of return, and you need to be able to beat this benchmark rate of return with pretty much 100% confidence (if you were to invest your cash flow elsewhere). - Better cash flow for your lifestyle.
If you pay only the interest charges every month, your monthly mortgage repayments will be smaller. Chances are, the rental income is sufficient to cover the interest charges and property holding expenses. This means you don’t need to sacrifice your lifestyle. You don’t need to dip into your salary, in order to pay for the investment mortgage.
CONCLUSION:
I am in 2 minds about whether to choose an Interest Only loan or a Principal & Interest Only loan.
It seems that to decidedly choose an Interest Only loan, I need to predict when I’ll be selling my property or asking for a loan top-up. If I ask for a loan top-up each year (which is a bit of an administrative nightmare), my benchmark rate of return is around 9.5%. If I ask for a loan top-up every 5 years, my benchmark rate of return is around 5.9%. I’m not confident to definitely achieve a 5.9% rate of return in the share market.
If I am happy to sacrifice my lifestyle and dip into my salary to fund my investment mortgage, I would choose a Principal & Interest loan. This also gives me the benefit of having different buckets of investments: SAFE (equity in my property) & HIGH RISK/HIGH REWARD (the share market and/or my business). By choosing a Principal & Interest loan, each month the bank will direct debit my account and ensure that I put in more and more money into the SAFE bucket. When I sell my property, my SAFE bucket will have a lot in it, and I can ponder what to do with all the money at that time. If I feel like taking risks, I’ll spend a few days thinking about it, and hopefully make a rational decision based on my circumstances at that time.
What are your thoughts?