There is a much-debated topic in the world of credit, it’s one that has been increasingly thrust into the spotlight in the last few years. Should you repay your loan using principal & Interest (P&I) repayments or Interest Only (I/O) repayments?
I have met more than my fair share of clients over the years who have an unwavering predisposition to only making P&I repayments. Usually a parent or a trusted friend has given them well-meaning advice or they just have a natural healthy fear of I/O repayments, avoiding something they don’t understand.
Nearly always though the situation is a lot more complicated than a basic decision whether to repay or not to repay the principal of the loan.
- Golden Question No. 1: Is the debt good, bad or ugly?
There are many different types of debt, loans secured against residential or commercial property, business loans, personal loans, margin loans, credit cards, store cards, loans with the tax department, I could literally go on and on with the different types of debt I’ve seen.Loosely though they can be categorised into 3 areas that I call the good, the bad and the ugly.
- Good Debt is any debt that is tax deductible and used for the purpose of buying an appreciating asset. The most common two examples of this are loans for residential investment properties and margin loans (loans for a share portfolio or managed funds).
- Bad Debt is debt that is not tax deductible but still has been used to buy an appreciating asset. The most common example of this is your home loan.
- Ugly Debt is debt that is not tax deductible and has been used to buy an asset that depreciates in value or is not secured against an asset at all. Examples of this are credit card debt, personal loans, car loans, etc.
As a general rule, both good and bad debt are repaid using I/O repayments, until all ugly debt is repaid in full (as quickly as possible). Then bad debt is switched to P&I repayments until fully paid off.
As with all generalisations though, there are exceptions to this rule. That leads us on to Question number 2.
- Golden Question No. 2: Is it your home for life or could it possibly be an investment property?
When deciding on P&I versus I/O repayments for your own home (i.e. your bad debt) you need to decide whether you will turn your home into an investment property at some stage in the future or whether you will live in your home until the day you sell it, pass it on to your children, etc.
This is an important question to answer, it can be the difference between the interest on your loan being tax deductible or not, which depending on the size of the loan can be a substantial amount of deductibility.
I’ve lost count of the number of clients I’ve seen who have been given bad home loan advice in the past, or who have not sought advice at all, thinking they are doing the right thing. Often, they head down to their local bank with a hastily researched plan of their own. Ultimately when they meet with an experienced adviser and are told of their predicament they want to fix the problem, but in almost every case it’s too little, too late.
If you have future plans to turn your home into an investment property, simply put, speak to us straight away. It’s very likely that you need to be making I/O repayments but there are specific structures that need to be set up as soon as possible so as not to erode your future tax deductibility.
Don’t get caught in the position where your current home has become an average (at best) investment property due to incorrect loan configuration.
- Golden Question No. 3: What’s your plan to repay your debt?
A simple formula when paying off a series of debts is to pay the minimum amount you can on the cheapest debts and then put the maximum amount you can into paying off the most expensive debt first.
If you’re making I/O repayments on bad debt, what’s your plan to pay the debt off?
- Are you making extra principal repayments into an offset account to reduce your interest and still
maintain your tax deductibility? - Are you investing the difference between the I/O and P&I repayments with your financial adviser and recycling the returns back onto your bad debt?
- Are you making extra principal repayments into an offset account to reduce your interest and still
Based on the above information you can make a relatively informed decision about whether to make P&I or I/O repayments. Like any decision though that affects your future finances, we recommend that you speak to an expect.
In this case your Credit Adviser can look at your specific situation and provide detailed advice for your unique circumstances. Contact us to book an appointment.
