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At the moment, we have an investment property where we're paying 4.5% interest on an interest only loan.

I'm considering moving to another bank which offer 3.88% fixed for 2 years but it can't be interest only – it has to be principal and interest.

This is obviously a huge difference in rates. It's about $5k difference a year in fact. However, is it a good idea to move to a principal and interest loan for an investment property?

As I understand it, if I have an interest only loan of 500k, then I'll always have a loan of that amount and the interest paid is always tax deductible. However, if it's not interest only, then every year, I'll owe slightly less, so the next year, I'll only owe 480k or something and then only the 480k will be tax deductible.

The question is, is it better to save 5k now and go with an interest and principal loan, or keep the maximum amount I can borrow so I can claim more on tax in the future?

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    This is very opinion based, but for my own I would say a interest only loan is almost always a bad idea. P&I is better for investment properties, but owning them outright would be ideal. – Pete B. Jul 6 '17 at 12:29
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    @PeteB. - In Australia we don't get a tax deduction on the mortgage interest for the house we live in, so if you have both a mortgage on your home and one on an investment property, then you are better (all other things being equal) having the investment on Interest only and your home on P&I - helping to pay your home mortgage off as soon as possible. So it is not based on opinion but on what makes more financial sense. – Victor Jul 6 '17 at 13:05
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    This is known as the tax tail wagging the dog. Still foolish in my opinion. Neither my home or rental property have mortgages. – Pete B. Jul 6 '17 at 13:15
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    If you buy a property with an interest-only loan you are effectively renting the property. I would rather pay myself principal (equity in the property) than pay the bank interest for a small tax break. – D Stanley Jul 6 '17 at 14:11
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    @DStanley - your statement is completely incorrect. The main reason for getting an Interest only loan should be for cashflow reasons, the tax break should be just a bonus, although some people do abuse it for the tax break without considering any risk management. These matters should be treated like business decisions and not based on your emotions or you feelings. – Victor Jul 8 '17 at 3:48
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Talk about coincidence, we just recieved letters from our bank saying that our interest only loans will be going up by 0.46% and if we want to keep our lower rate we will need to change early to P&I. Now our Interest only periods end in 6 months to about 16 months anyway.

We have decided to change to P&I early and save on our interest expenses.

Why? Because the main purpose of investing is to make money not to save on tax. Even if you are on the highest marginal tax rate for every extra dollar of expenses you spend and claim as a deduction you will only get about 50 cents back through tax savings. If you are on the lowest marginal tax rate your tax savings will reduce to less than 20 cents for every extra dollar spent.

If you are investing in order to save on tax you may be investing for the wrong reasons. Your primary reason for investing should be to make money, for wealth creation.

A good reason to stay with an Interest only loan for an investment property would be if you require the extra cash flow you would receive compared with an I&P loan.

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    Two great points here: Because the main purpose of investing is to make money not to save on tax [something often forgotten by people getting caught up in tax calculations]; and A good reason to stay with an Interest only loan for an investment property would be if you require the extra cash flow you would receive compared with an I&P loan. [Because the extra principal payments reduce your loan balance, they are a cash outflow, but not an expense, so if you have the cashflow, paying the extra principal is not so bad]. – Grade 'Eh' Bacon Jul 6 '17 at 13:12
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Paying interest on a loan costs you money. The tax deduction just reduces that cost, but it's still there. So the only possible reason to borrow more than you have to, e.g. with the interest-only loan, is that you can invest the excess elsewhere and make more money.

Can you invest money and make more than 4.5% expected return before tax with a risk level you're comfortable with? If you can invest tax free then the hurdle is (4.5%-the tax deduction instead), e.g. 3.6% if your marginal tax rate is 20%. One possible such investment would be paying down any mortgage on your own home - as you don't get a tax deduction for such a mortgage, overpayments are effectively tax free so 3.6% or whatever is the appropriate hurdle.

If you can't do that, then even switching to a principal and interest mortgage at 4.5% would be worthwhile; the principal payments would effectively be an investment in reducing your future interest bill, and that investment is better than anything else you have available.

Given that what you actually have on offer is a mortgage with a lower rate of interest, the hurdle for an alternative investment is quite a bit higher than 4.5%; with the interest-only mortgage, you can invest some of the money that would otherwise go to principal elsewhere, but in exchange you are paying a higher interest rate on the rest of your loan balance. You'd need to look at the exact numbers to work out the right hurdle, which would vary depending on your marginal tax rate, the term of the mortgage, and your guess as to where interest rates would go after the 2 year fixed term.

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