Is Principle and Interest (P&I) or Interest Only (IO) better on my investment loan?

Mortgages and interest rates, they are extremely confusing. Here is a recent problem I had, should I go Principle and Interest (P&I) or  Interest Only (IO) on an investment loan. Initially, these seams an obvious choice, go the IO and deposit the saved principle payments into your owner occupied offset, as you are unable to claim the interest at tax time. But this gets a bit more complicated when the P&I interest rate is slightly lower.

Here is how to work it out.

Lets assume your Owner Occupied rate is 4%, IO investment is 5% and P&I investment is 4.8% (0.2% discount). Loan amount is $500,000, payment over 30 years.

To work out the principle payments each month the Excel formula PMT can be used.

=PMT(4.8%/12, 30*12, 500000)

Which results in monthly payments of $2,623 or yearly payments of $31,480. This is the amount that won’t be able to offset the Owner Occupied at 4%, this is equal to $1,259 a year.

If the P&I and IO rates were the same, we wouldn’t want this loss and stick to the IO, but it isn’t the case. at 4.8% interest first year is $16,800, whilst IO at 5% is $17,500, a difference of $700. 

In this case, P&I costs $559 more a year, and it would be better to go IO, even at a slightly higher rate. Simply, right? Well, not quite.

As investment loans are tax deductible, comparing the interest only isn’t a fair comparison. In a situation where P&I is more cost effective then IO initially, it is worth then calculate the interest payable after factoring the tax deduction. It may make the IO more favourable. But if it does, the savings differences may be negligible compared to other factors.