Interest Only vs Principal and Interest: Tax Impact for Investors
Loan structure can significantly affect your investment property's cash flow and tax deductions. Interest-only loans maximise short-term deductions, while principal and interest builds equity faster. Here's how to weigh up the trade-offs.
| Interest Only (IO) | Principal & Interest (P&I) | |
|---|---|---|
| Tax deductions | Higher (100% of repayment is interest) | Lower (only interest portion deductible) |
| Monthly repayments | Lower during IO period | Higher from day one |
| Equity build | None (loan balance unchanged) | Steadily reduces loan |
| Interest rate | Typically 0.2–0.5% higher | Lower rate |
| Long-term cost | More total interest paid | Less total interest paid |
How Interest Deductions Work
Interest on a loan used to purchase an income-producing investment property is fully tax deductible in Australia. This applies whether you use an IO or P&I loan structure. The key difference is that with IO, your entire repayment is deductible interest.
Interest Only ($500k at 6.5%)
Monthly repayment year 1:
- Monthly payment: $2,708
- Deductible portion: $2,708 (100%)
- Annual deduction: $32,500
P&I ($500k at 6.3%, 30yr)
Monthly repayment year 1:
- Monthly payment: $3,100
- Deductible portion: ~$2,625 (85%)
- Annual deduction: ~$31,500
When Interest Only Makes Sense
- You also have a home loan: Pay off non-deductible debt first while maximising deductible interest
- Cash flow is tight: Lower repayments free up cash for other investments or expenses
- You're negatively gearing: Higher deductions reduce your taxable income more
- Short-term hold strategy: Planning to sell within 5–10 years, equity build matters less
When P&I Makes Sense
- No other debt: Without a home loan, building equity in your investment makes sense
- Long-term hold: Over 20–30 years, P&I saves significantly on total interest
- Lower LVR goals: Reducing your loan balance improves your borrowing position
- Risk management: Reducing debt protects against interest rate rises or property value drops
The IO Expiry Trap
Most interest-only periods last 1–5 years. When the IO period ends, your loan switches to P&I repayments over the remaining term. This can cause a significant repayment shock:
- A $500k loan on 5-year IO then 25-year P&I: repayments jump from ~$2,708 to ~$3,400/month
- Refinancing to a new IO period is possible but not guaranteed — lenders reassess your serviceability
- APRA regulations have tightened IO lending criteria since 2017
Loan Structure Strategy
A common approach for investors with a home loan is to structure debt so that:
- Home loan: P&I to pay off non-deductible debt as fast as possible
- Investment loan: IO to maximise deductible interest and free up cash for the home loan
- Offset account: Attached to the home loan to reduce non-deductible interest
Important: Never mix personal and investment funds in loan accounts. Redrawing from an investment loan for personal use can compromise the tax deductibility of the interest.
Model your investment property cash flow
Compare IO vs P&I scenarios with rental income, expenses, and tax deductions side by side.
Open Investment Property CalculatorFrequently Asked Questions
Is interest on an investment property loan tax deductible?
Yes, interest on a loan used to purchase an investment property is fully tax deductible in Australia. This applies to both interest-only and principal-and-interest loans. Only the interest portion is deductible — principal repayments are not.
Do I get a bigger tax deduction with an interest-only loan?
Yes, in the short term. With an interest-only loan your entire repayment is deductible interest, whereas with a P&I loan only the interest portion is deductible. However, IO loans typically have slightly higher interest rates, and the deduction difference narrows over time as P&I interest reduces.
How long can I have an interest-only loan in Australia?
Most lenders offer interest-only periods of up to 5 years for investment loans. After the IO period ends, the loan typically reverts to principal and interest with higher repayments over the remaining term. Some investors refinance to a new IO period.
Should I use interest only for my investment property and P&I for my home?
This is a common strategy. Since home loan interest is not tax deductible, paying it off faster with P&I saves you more. Meanwhile, keeping the investment loan on IO maximises your deductible interest. Always check with your financial adviser before structuring loans.