Cash Flow

Principal and Interest (P&I) vs. Interest Only (I/O)

We are investors, so I assume you all know what P&I and I/O loans are. Let’s quickly recap the pros and cons of each. 

P&I advantages

  • By paying off principal, the equity in the property increase (assume the property is not reduced in value)
  • You have the flexibility to swap into interest only if cash flow gets tight to release more cash.
  • By paying extra for principal reduction, you are more disciplined towards paying off your loan quicker


The main disadvantages of P&I

  • You have less cash to invest and
  • The principal portion of investment property loan is not tax deductible.  

Obviously, the I/O option has the opposite pros and cons. 

So How Should We Pay the Loans Off?

It’s best to structure the non-deducible debt on your home on a P&I basis so you can pay it off as soon as you can and discharge the family home from the bank. At the same time leave the deductible investment debt on I/O. This maximises tax deductibility and therefore improves your cash flow as you get a larger tax refund (if you incur a loss) or pay less tax (if you made a profit)

Once your home is paid down, apply your surplus cash flow to pay down your investment loan voluntarily by storing the cash in a line of credit facility and pay it down to zero. Any further surplus you make lump sum payments upon refix to reduce the loan balance. The loan can still be kept on Interest only so that if you want to buy more properties, you can reduce the voluntary payments and use the extra cash to buy more.

Never let your savings sitting in the bank’ saving account. You probably can earn 3% interest but after tax, only 2% but you are paying 5% on loan which does not make sense. Put it into a line of credit or use for debt reduction. Little things add up to a big thing.

On the flip side, we recommend don’t stretch your cash flow too thin as if the market goes down, experiences high-interest rates, job loss, etc. you will have no alternative but to become a forced seller in a depressed market and lose all the wealth accumulated to date.

Line of Credit

The beauty of line of credit is that you can redraw the cash you put in before when you need it without applying form the bank, but reduce interest paid if you don’t use it because the bank only charges against loan balance, not on loan limit.  Note bank charge annual fee for having a line of credit facility, normally this can be waived in the first year and it is tax deductible expense as well.

I highly recommend every property investor should have a line of credit facility. During GFC period, the interest rate was close to 10%. Lots of investors were forced to sell their properties due to loan repayment issues (the rent was unable to cover the mortgage interest costs and investors do not any surplus cash to cover the shortfall). If they had a line of credit (either undrawn or semi-undrawn) then they were more likely to ride out the tough times and save their properties.

A key cash flow risk mitigation strategy for property investment is establishing a line of credit in advance of needing them to cover cash flow if you lose your job or tenants or deal with cash flow shortfall.

Remember, the bank can be your best friend in good times, but your worst enemy during your tough times. If you admit you are in trouble, they are more likely to react adversely.

Manage interest rate fluctuation

When considering interest term strategy, cheapest is not always the best. Interest can fluctuate for many reasons, such as OCR, local deposit rates, wholesale rate, etc, sometimes it’s hard to predict. If you fix all your loan at the cheapest interest rate, upon refix, 1% rate change on $2m loan requires $20k additional cash per year to cover extra interest cost alone.

The interest you pay on your loans can have a huge effect on your overall cash flow. Even a small change in interest rate can have a big effect on your bottom line. Banks will not demand loan repayment due to negative equity however you can definitely get into trouble if you can’t keep up with the loan repayment. People often laser focus on what the cheapest rate on offer by the bank but instead they should focus on managing interest rate fluctuations such as having slightly longer fixed terms or spreading the risk by having a number of tranches expiring at different times.

Splitting Banks is helpful

Bank’s pricing appetite can change from the best in the market to the worse depending on their strategies. By splitting your loans across different banks, you are not exposed to adverse interest rate upon refix should the bank decide not to match pricing with their competitors. 

Have a good property manager

A good property manager can avoid your property being trashed by bad tenants, and they will maintain your property by doing inspection regularly, collect rent on time, review rent to make sure you receive the market rent. The fee you pay can easily offset by rent increase and give you peace of mind. I personally use a property manager to manage all my properties. 

Look for Positive Net Yield Property

In the Strategy section, we discussed the importance of having a balanced portfolio. Cashflow property won’t make you rich but important for supporting your capital growth properties. The surplus cash flow from the high yielding properties supports the outgoings on the capital growth properties.

Basically, when it comes to yield, there are two types: gross yield and net yield. But what’s the difference between gross and net?

Gross yield is everything before expenses. It is calculated as a percentage based on the property’s cost or market value divided by the income generated by the property.

Net yield is everything after expenses. It considers all the fees and expenses associated with owning a property. Some expenses are water rates (fixed portion), council rates, maintenance and repair, property management fees and insurance, etc. Ideally, we want to seek a property has positive net yield. If you can’t find the cashflow properties, you can consider buying a small business which creates additional income to help subside investing activities. 

Pay Off the Cashflow Property First

With cashflow property, as you are less likely to create wealth through capital growth and if you keep it over the long term, the return would be very poor despite all those hassles of managing it. By paying off the loan at least you are saving. 

ENQUIRE NOW CALCULATORS

We initially approached Connie regarding our home loan refinance because my wife normally worked during daytime but I worked at night shift for 3 days a week. It was not convenient for us to go to bank directly.

Connie went to our house during night time where both of us were available to review our existing home loan and discuss our financial goals. She sorted everything for us with a breeze. We were not only successfully refinanced existing home loan and secured very good interest rates and cash rewards but she also managed to help us finance our first rental property without any cash deposit by leveraging our home equity which we were not aware of before. She also gave us great advice on how to manage our home loan so they can be paid off quicker and build wealth through property investment.

We definitely recommend Connie because her knowledge, experience and expertise in finance gave us peace of mind. She is always there to help us and keep us updated regarding our home loans.

Person

Jose and Marilou Suerte

Proud parents of two lovely children