More on the P&I versus IO debate

[Gerrard]

I've been doing a bit more analysis on the IO versus P&I approaches. Every deal I analyse givers far greater long term benefits from P&I (factoring in any annual profit / loss plus the equity gained by paying the mortgage down). This blew me away. I had heard so many "experts" saying IO was the way to go that I just assumed it was. I guess I'm the kind of person that needs to see it myself to believe it.

The thing I am still weighing up is that using IO I could quite easily build up an income stream of $20k+ p.a. in the next year or so with the equity I have available. That's quite attractive. On the other hand, if I am prepared to sacrifice this short term income I could have a far greater one in 10 - 20 years time. Hmmmm, delemas!

When doing the calculations on my own properties, I find I would have to commit money each year to meet the principle payments. Is anyone in the same situation? I guess after a while the snowball effect starts to happen and the profits from properties that you have owned for a while go into supporting the newer ones.

If you haven't committed your own cash, and are planning to pay off the mortgage in less than the standard 25 year period, it suggests to me that you are getting some huge gross returns. Perhaps I haven't set my sights high enough!

Comments appreciated.

Thanks
Gerrard

[graemeh]

Re: More on the P&I versus IO debate

The thing I am still weighing up is that using IO I could quite easily build up an income stream of $20k+ p.a. in the next year or so with the equity I have available. That's quite attractive. On the other hand, if I am prepared to sacrifice this short term income I could have a far greater one in 10 - 20 years time. Hmmmm, delemas!

If you are trying to increase your investment portfolio I believe IO is the way to go, it gives you more spare cashflow. In your case you mention an income stream of $20k+. There is usually nothing to stop you paying this money off your IO loan each year.

With a variable rate IO loan there should be no problem paying off principal, it's just that you don't have to. The choice is yours. It's also a whole lot easier to see how much is being paid in interest and how much is going to principal if you have an interest only loan.

I believe the ultimate loan is a 25 - 30 year revolving credit loan but this type of loan requires a disciplined approach. I think of it like a loaded gun, it's a useful tool but can be dangerous in the wrong hands.

Our strategy is to use interest only loans until we have a big enough portfolio and then start repaying loans.

[orion]

On the other hand, if I am prepared to sacrifice this short term income I could have a far greater one in 10 - 20 years time. Hmmmm, delemas!

Hi Gerrard, there are two dilemmas or pains in life - the pain of discipline which is short term, and the pain of regret which is long term.
It really is a decision you will need to make. Personally, you know what my answer would be. I want the tenants to buy the property, that is pay it off for me. If I have to pay for it, or wait for it to possibly go up in value one day, some day - then I don't want it. Also, if I get $1,000 or so cash from it a year, that is not something I would be happy with long term. I would not be prepared to wait for how long ever it would take, for it to be worth a far greater amount than what the market value was, when I bought it. Who knows, in 10 years time, properties may even be worth less than what the market would pay for them today. I am not prepared to take that chance, even if it is a slim chance. I don't gamble and to me even though the risk may be slight, I wouldn't take the bet and put everything I own on the line for a guess of what will happen in the future.
But my main point again is that an investment is something that someone else pays you to own.

When doing the calculations on my own properties, I find I would have to commit money each year to meet the principle payments.

You just need to increase your deposit slightly to make up for it.

If you haven't committed your own cash, and are planning to pay off the mortgage in less than the standard 25 year period, it suggests to me that you are getting some huge gross returns. Perhaps I haven't set my sights high enough!

Most mortgages are either 20yrs, a very few are 25, some are 15 and some are 12. I think 20 yrs is a good figure to go with when starting out.

Regards
Graeme Fowler

[Gerrard]

Our strategy is to use interest only loans until we have a big enough portfolio and then start repaying loans.

I was thinking down that track myself for a while. However what would I do with that additional cashflow now? I'm pretty disciplined with money so could use it to pay off my own home. However it would be quite easy to just go into the pot and end up being spent on that Fiji holiday, or updated car, or nicer couch.

Instead of taking that risk I'm now thinking leave the cashflow in the properties to pay off the mortgage. This is where the real benefits come from. After all you don't take the interest on a bank deposit (or dividend on a share) out at the end of the year. You let it compound and you get the exponential benefit rather then just linear.

You just need to increase your deposit slightly to make up for it.

I have been borrowing 100% using equity from my own home, so haven't been putting in "real cash". By raising my criteria of what to purchase, I can make this work without putting in any cash.

Gerrard

[cube]

When doing the calculations on my own properties, I find I would have to commit money each year to meet the principle payments.

You just need to increase your deposit slightly to make up for it.

How far do you take this - if you have to put in sufficient deposit to make sure that the repayments cover the rent, then don't you run the risk of negative gearing?

cube

[drelly]

However what would I do with that additional cashflow now?

I'm on IO and have some extra cashflow. I'm using it to tidy up the properties, redecorate and paint the roof. Don't let yourself get into the situation where you have no spare cashflow to help you out when something goes wrong.

[graemeh]

[However what would I do with that additional cashflow now? I'm pretty disciplined with money so could use it to pay off my own home. However it would be quite easy to just go into the pot and end up being spent on that Fiji holiday, or updated car, or nicer couch.

You can use it to pay off some of your loan. Just because it's interest only doesn't mean you can't pay off principal. I view 30 year loans the same way, just because it's 30 years doesn't mean I can't pay it off quicker.

Having interest only and a long loan term just gives you flexibility and revolving credit is the ultimate in flexibility, if you have spare money put it in the loan. If you need it back, take it back out again. The more spare money you park in your revolving credit the greater your protection if something bad happens.

[orion]

How far do you take this - if you have to put in sufficient deposit to make sure that the repayments cover the rent, then don't you run the risk of negative gearing?

Hi Cube, when people say 'negative gearing', they often are meaning very different things, and therefore it depends on the individual's perception and interpretation of what it means to them.
To me, I view it as the rent covering the mortgage, rates & insurance + say a couple of thousand dollars per annum for maintenance. I don't take into account depreciation. To get this in most areas nowadays, you will need to put in a deposit so that these costs are all covered (so the mortgage payments are reduced), unless you buy in low priced areas, or locations that most people do not want to live.
There is a point though where it is not worth doing, no matter what the deposit you put in. To speak in terms of 'yield', anything below about 6 -7%p.a. to me would not be worth buying. Example a $200,000 property would have to rent at $14,000 p.a. or $270 p.w. This means the property will return 7% p.a. of the property's price by way of rent, if it were freehold. Now, if that same property was worth $400,000 and still could only manage the same amount of rent, it would require a far greater deposit to make it 'neutral or slightly positively geared' therefore making it not feasible.
Many investors in Sydney for example are still buying properties with 1- 2% 'yield' on interest only which to me is just outright insane. Either they are highly negatively geared, or are putting a huge amount of their own cash as a deposit (or other equity which will only go so far, thereby limiting future purchases), so all outgoings are covered. There are relying solely on capital gain, nothing else.

Regards
Graeme Fowler

[tamara]

Hi

I have been reading this thread with interest. We have been purchasing our properties under a P&I and revolving credit structure. I guess that we like the idea that we likily live in a tax free environment and are earning good money.

As we live as expats we do purchase with 20% deposit and do try and purcase at the 7% return level. It might take us a bit longer to get to our end result but we feel very happy with the fact that we can pay off Principal as well as interest and will feel long term benefit from this, we will be able to put spare money into our property and draw it out when necessary and have security in knowing that we have buffer money also ready to draw up should it required. We do this by reinvesting any income into the mortgages.

Along with all of this we are still able to save and purchase again with 20% deposit.

Perhaps if we were residing in NZ and purchasing we might structure things a little differently.

Tamara

[orion]

Well done Tamara, sounds like you are doing really well!

Regards
Graeme Fowler

[cube]

when people say 'negative gearing', they often are meaning very different things, and therefore it depends on the individual's perception and interpretation of what it means to them.

Agreed - I think we tried to define it in another thread - so lets talk about positive cashflow instead, and if its not positive cashflow it must be negative(!).

For me positive cashflow means that rent is greater than (mortgage interest + rates + insurance + maintenance), assuming a 100% loan. If I have to subsidise that, then I have less to spend on the pokies each night (only joking!)

If the loan is less that 100%, then the mortgage is less but I have had to put in some cash. Then it comes down to is this property the best place for my $40,000 (for a $200K house) , (assuming that I have $40,000 to play with ).

Now, to look at P&I, putting in some of my ready cash to pay off the capital each month is fine, if that's what I choose to do, and Gerrard's calculations make it look as though that requires another look, but for me, a property has got to pay its own way first.

That would be my 2c, but I just used it to pay off some capital.

cube

[Gerrard]

Now, to look at P&I, putting in some of my ready cash to pay off the capital each month is fine, if that's what I choose to do,

Now that's where the trick is. I've been assuming I would have to put my own cash in. Wrong! I'm now assuming I won't have to put any cash in because I will find a property that is cashflow positive even after principle payments.

Gerrard

[cube]

OK, I've been doing some figures of my own, and the results surprised me, too. Like Gerrard, I had heard that getting a high cash flow from day 1 allows you to leverage your way to more investment faster, but in fact the opposite is true.

Now, the following scenarios are simplistic - I have ignored capital growth, inflation, other expenses, the ability to add value, interest earned on cashflow whilst saving for another property etc., but the picture is revealing. Get your calculators out, and come with me on a ride through the figures......

If anyone thinks I've got something wrong, please let me know, and I'll update the figures.

Happy calculating

cube

Scenario 1

I buy a $200,000 house with a 80% mortgage at 7%. I manage to find a nice tenant who pays $1857 per month (yield of 11.1%, I know, but it keeps the figures simple), being the repayment on a P&I loan over 10 years.

At the end of 10 years, I have a mortgage free property worth $200,000.

Net Worth after 10 years = $200,000 + ongoing cashflow of 1857 a month

Scenario 2

I buy the same house, have the same tenant who pays the same rent, but pay interest only on the mortgage ($933 per month).

After 10 years, I have made $110,928 in profit (interest - rent), have a $200,000 house and a $160,000 mortgage.

Net worth = $150,928 + ongoing cashflow of 924 per month. (assuming I didn't spend the cashflow)

Scenario 3

As for scenario 2, I buy the same house, have the same tenant, who pays the same rent and I pay interest only. But when I have saved $40,000 (in month 44), I buy another $200,000 house with a 20% deposit and rent it out to the tenant's brother for the same rent.

At the end of the original 10 years, I have property worth $400,000, mortgages of $320,000, and have received $71178 in profit from the second house.

Net worth = $80,000 + $70928 + $71178 = $222106 + ongoing cashflow of 1848 a month

Scenario 4
As for Scenario 1, I buy the same house, have the same tenant, who pays the same rent and I pay P&I, but when I have amassed another $40,000 (month 39) in equity, I buy another $200,000 house, getting the same rent etc.

At the end of the original 10 years, I have property worth $400,000, a mortgage of $63152

Net worth = $336,847 and a cashflow of $3338 a month and still rising.

[Gerrard]

Bingo Cube! Basically the same conclusions I came to, with different numbers.

Ok so you sacrifice the short term income stream, but most people are capable of supporting themselves on paid employment for the next 10 years or so. After that time the income stream is suddenly much bigger, plus you have the security of a debt free investment, and the ability to leverage it for further investments. It's all good!

One of the "benefits" that some people relate to IO is that the interest is tax deductible, so by not paying off principle you are maximising deductions and minimising tax . What a crock! I'd rather pay the tax and have a better result.

Cheers
Gerrard

[drelly]

Yeah but... statistics can prove anything if you use them right!

Do I agree with you that P&I is a quicker way to get rich? Yeah sure... absolutely! Is IO a quicker way to get rich? Yeah sure... absolutely!

My point is that if you create the right premises, you can prove either of them to be better. I often hear people say that one type of investment is better than another. That's bollocks. The reality is that they are all good in different circumstances. Is fixed interest better than property? "No!" I hear you scoff! Well... it is if the reality of your property investment is that you bought badly and lost your money.

In the same way, IO *can* be far more effective than P&I if the extra risks you take by going down that track pay off. If the extra risks don't pay off then you'd probably look back with your 20/20 hindsight and say that P&I is better.

You can't effectively prove IO to be a lesser option if you're going to ignore the (intangible) expenses, capital growth, added value and extra options that come from the cashflow that IO gives you.

The fact is that there are risks involved in any form of investment and these will vary depending on your personal circumstances. For some, P&I could well turn out to be more risky than IO! The trouble with intangibles is that they don't readily fit into a calculation. As we all know, life does not behave according to our projections!