I am writing this article on the simple assumption that if you borrow money you should have a plan to pay it back. I cannot think of a simpler and more self-evident statement.
There is a time and place for Interest Only (IO), as it has some excellent strategic applications. But far too often it’s over emphasised and ends up being a long term strategic mistake. To be at the doorstep of retirement with a lot of debt that necessitates asset sales (downsizing of home, investment property sales, share portfolio sales etc.) is generally bad long term planning. A lot of “self-directed” investors end up in this spot.
Inside an SMSF, an IO loan with an offset account is a great way of managing your debt and your cash. I actually cannot understand how a bank can be in the SMSF Loan business without offering offset accounts.
It is also perfectly reasonable to manage your investment debt (tax deductible) on an IO basis while you have home loan debt (non-deductible) still to pay off. But once the home loan is paid off you need to get stuck into the rest of your debts.
Interest Only simply put is borrowing money without paying it back. It is the structure of choice in Australia for a variety of ideas and rationales, some of which are flawed.
To begin with let’s first look at the maths to understand what we are talking about. I am using an interest rate a bit higher than current variable home loan rates but a lot lower than many other forms of debt.
|Interest Only (IO)||Principal & Interest (P&I)|
|Annual Extra %||1.2%|
|Extra Total $||1,200|
|Total Extra Capital||36,000|
|After 30 Years|
|Per Annum $||Per Month $||Extra Per Annum %|
Some broad conclusions from this table:
- The extra capital required to pay back the 100,000 loan is 36,000.
- The cash flow difference between IO and Principal and Interest (P&I) is only 1.2% of the loan balance. A negligible sum. If you have a 500,000 mortgage, an extra 6,000 p.a. or 500 pm is all it takes to eventually pay off the entire loan. If you cannot afford the extra 500 pm, then you have simply borrowed too much (regardless of what the bank says you can borrow).
- Gradually paying off the debt will save you 64,000 per 100,000 borrowed over 30 years. We all have loans that are several multiples of this number. If you have debt of say 700,000 that is mainly IO, you could save yourself 448,000 (7 times 64,000) by repaying the principal (by simply finding 161 per week from your budget).
- An extra 0.5% (increasing the repayments from 1.2% of loan to 1.7% of loan) will shave another 5 years off the loan, and so on.
There have been several distinct forces that have led to the wide spread adoption of IO loans in Australia.
Banks, Taxation and the siren call of Deductions
There is a clear bias within banking to have customers in debt for longer. A bank will only make money if you are paying interest on a loan, the longer the better. So obviously your banks advice will be towards more debt rather than less with more favourable repayment structures rather than accelerated payment terms. Australian banks do not worry about getting their money back as the loan to value ratios are low by overseas standards and a property can easily be sold to recover the principal of the loan.
Financial and Accounting advice has steered too many people towards maximising deductions at the expense of all other considerations. The tendency is to encourage more deductions rather than less without understanding or considering the long term consequences.
A good rule of thumb is that if you cannot afford the repayments on a P&I (30 year) loan, you have borrowed too much. The small difference between the IO and P&I repayment should not justify your borrowing.
There is wide spread financial illiteracy on how loans work. We can all agree that IO is not rocket science because it is a logical and linear calculation that everyone can do in their head (primary school maths). But P&I is frankly rocket science, it is a non-linear (illogical) equation that hardly anyone I have ever met understands (before it is explained to them). The idea that in paying back to the bank 36,000 extra you can extinguish a 100,000 principal of a loan is counter intuitive and illogical.
The typical investment property construct in Australia has been to borrow as much as possible, get a tax deduction on the yearly losses, pay interest only on the loan and wait for the market to “inflate” your property and create growth. This is a strategy that relies on growth only to create your equity and wealth.
Adopting a debt repayment approach will end up creating equity in 2 ways, via the growth on the property value if and when it occurs plus the repayment of the debt. This strategy makes you less dependent on growth and allows you to end up with an unencumbered asset regardless of the amount or timing of the growth of the property. It allows you to own that property “forever” and live off its free rent/cash flow. This is a more prudent and less speculative way of managing your balance sheet and your life.
Debt is one of the most valuable tools we have in creating wealth, as long as there is a clear strategy and pathway to paying it back, preferably not reliant on asset sales. If you rely on selling the asset to pay back the loan, then you are dependent on market timing (it may be either a good or bad time to sell the property) that has to coincide with when you are ready to retire. There is a fair bit of luck in this strategy and it will not work for the majority of people. Everyone cannot get that lucky.
In conclusion: If you borrow money, have a plan to pay it back.