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Interest-only vs principal & interest: when IO makes sense

Interest-only (IO) loans make lower monthly repayments than principal-and-interest (P&I) loans, but you don’t pay down any of the loan balance during the IO period. Here’s when that trade-off actually helps you.

The four scenarios where IO genuinely wins

1. Investment property, maximising tax deductibility. Interest on an investment loan is tax deductible; principal is not. On a $500,000 investment loan at 6%, that’s $30,000 a year of deductible interest - worth roughly $11,000 to $14,000 a year in tax savings at a 37-47% marginal rate. Paying extra principal down on an investment loan while still carrying owner-occupier debt is a common, expensive mistake.

2. Building a portfolio. If you plan to buy a second or third investment property, keeping current investment loans at IO preserves cashflow for servicing new loans. P&I on a portfolio of four properties burns through serviceability capacity fast.

3. Temporary cashflow squeeze. Maternity leave, career transition, business slow quarter. A 12-24 month IO period buys you breathing room at a small rate premium.

4. Expecting a lump sum. Inheritance, share vest, deferred compensation. If you know a significant cash injection is coming in 18 months, IO now and a P&I lump-sum payment then is cheaper than P&I throughout.

The three scenarios where IO loses

1. Owner-occupier home with no tax angle. Interest isn’t deductible, and you’re just deferring principal repayment at a higher rate. Over a 5-year IO period on a $700,000 loan, you pay ~$15,000 more in interest than under P&I, and at the end of year 5 you still owe the full $700,000.

2. You’ll never clear the debt otherwise. IO loans are often taken by borrowers who can’t afford P&I - which means they’re financially vulnerable. A rate rise on an IO loan is a pure cashflow hit with no offsetting principal reduction. These files are APRA’s biggest concern.

3. Near retirement. Lenders are tightening on IO loans where the exit strategy depends on selling the property in retirement. If that’s your plan, lenders want to see it documented with realistic numbers.

The reversion step-up

At the end of the IO period, the loan reverts to P&I - but over the remaining term. If you had a 30-year loan with 5 years IO, the last 25 years have to amortise the full loan balance. On $700,000 at 6%:

  • P&I over 30 years: $4,198/month
  • P&I over 25 years (post-IO): $4,510/month - a 7.4% step up

That 7.4% jump is painful but survivable. Longer IO periods hurt more: 10 years IO plus 20 years P&I means a P&I payment of $5,013/month, a 19% step-up vs the original P&I.

The APRA stance

APRA caps IO lending at roughly 30% of each lender’s new business. Most lenders now grant IO only on investment properties, with owner-occupier IO available in exceptional circumstances. This is tighter than pre-2017 and is unlikely to loosen.