P&I or IO? - Best Loan Structure for Investment Property Explained

Published 19 January 2021 by Team :Different

If you browse property investing forums and real estate news sites you’re bound to have come across the question “P&I or IO?” on the topic of property finance and property loan structure. No doubt, those abbreviations had you scratching your head, coffee in hand, if you are an aspiring investor with little prior knowledge.

IO and P&I are short for Interest-Only (IO) and Principal and Interest (P&I). They’re different property loan structures, and are super important to make some thoughts about during property financing, as they have an impact on your property investing interest rates and what you’ll be paying. 

Neither is a silver bullet, and you need to choose the one that is best suited for you in your property investing journey.

To help you find your best loan structure for investment property, we’ve explained the key terms you may come across, the pros and cons of IO and P&I, and when to choose what, so that you can make a smart financial decision with confidence.

Investment property mortgage definitions to remember

First you need to know the basic terms thrown around when it comes to home loans and property investing interest rates, so let’s break some of them down. 

  • Interest rates are the percentage of your loan that you pay your lender for the use of their assets.  
  • Fixed interest maintains the same interest rate throughout your borrowing period, while variable interest is an interest rate that will change over time. 
  • The effective rate is the rate of interest that you will pay annually after you take compounding interest into consideration. 

Now that we’ve covered some of the basic terms, it’s time to tackle the big decision: interest-only or principal and interest.

What is an interest-only property loan?

An interest-only mortgage means that for a set initial period you will pay back only the cost of interest on your loan. This period is usually one to ten years, after which you will begin paying both interest and repaying the amount that you borrowed (principal and interest).

Benefits of an interest-only loan structure

By choosing this property loan structure you get to enjoy:

  • Lower repayments for your set initial period.
  • Allows you to save or prioritise other payments. 
  • You can give yourself time to spend more on your investment property - style it with furniture, renovate, and ensure that it’s in top notch condition for your future tenants.

Disadvantages of an interest-only loan structure

That being said, interest-only property mortgages come with a few potential drawbacks:

  • You could pay more interest over the course of the loan as interest rates may be higher. 
  • It may take you longer to pay back your loan as the loan is not reducing while you are paying interest-only.

So, when should you choose interest-only loans?

Interest-only loans are suitable during times of uncertainty, market fluctuations, if you're financially spread thin and if you're looking to take on multiple mortgages for several properties.

Interest-only loans require a lower monthly payment, and make more sense if:

  • You are buying an investment property while still paying off another mortgage. 
  • You are facing temporary lowered income e.g. due to switching jobs, starting a family, moving.
  • You are transitioning your current home into an investment property.

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What is principal and interest?

Now, let's switch gears and talk about P&I (principal and interest).

Unlike interest-only, with principal and interest you repay your loan as well as interest. You may choose to begin your repayments in this format, or switch to it after an initial IO period. 

Benefits of choosing principal and interest loans

Principal and interest loans come with the following benefits:

  • You will likely pay less in net interest over the entire course of the loan.
  • Banks will often offer you better interest rates if you choose principal and interest. 
  • You can repay your loan sooner and own your property outright.

Disadvantages of principal and interest loans

The main drawback of choosing principal and interest loans is that you have higher repayments from the get-go, meaning potential financial strain if you’re paying off other debts or wish to spend more on renovating your property.

So, when should you choose principal and interest?

Principal and interest loans are best suited during strong market periods, granted you are in the financial position to make higher early repayments on your loan.

While this loan structure demands higher payments in the short term, in the grand scheme of things it will save you money and helps build your equity faster. You should choose principal and interest loans if:

  • You are in the financial position to make higher repayments on your loan.
  • The market is strong, so you can increase the equity in your property.

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Interest-only vs principal and interest case study

Say hello to Steph, an imaginary aspiring property investor.

Steph has recently finished paying off her personal home loan, so she has decided to purchase an investment property - exciting times! 

She's read our article on how to find the right mortgage broker, and knows who to go to for her finance needs.

She needs to borrow $300,000 and uses a mortgage calculator to compare investment property interest rates and what her repayments would be for both IO and P&I options.

Setting the interest rate at 2.99%, with an interest-only period of 5 years on a 25 year home loan, she will pay a total of $446,800 over the full course of the loan. Her monthly repayments during the 5 year IO period will be $758, after which they will increase to $1,672.

If she chose the P&I option, Steph will pay a total of $429,322, which amounts to $17,478 less than the IO option. This would require her to make monthly repayments of $1,431.

interest only vs principal and interest case study

What should Steph choose?

As Steph has no other current loans that she is paying off and is in the financial position to make high repayments from the start, P&I would be the best option for her. She will save money in the long run and can increase the equity of her investment property sooner. 

While P&I would be the best route for Steph, there are clear benefits to both options, and neither is going to be perfect for every situation.

There is no silver bullet to your property financing. Make sure you do deep research into your situation, and seek financial counsel to help make your decision.

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Disclaimer: The views, information, or opinions expressed in this blog post are for general information purposes only and should not be relied upon. We have not taken into account specific situations, facts or circumstances, and no part of this blog post constitutes personal financial, legal, or tax advice to you. You should seek tax advice from your accountant, specific to your situation.

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