The question of interest only vs principal and interest on an investment property is not really about which repayment is lower. It is about what happens to the money you do not send to the bank.
Principal repayments on an investment loan cannot be claimed as a tax deduction. Every dollar you put toward reducing principal is an after-tax dollar. If you earn $700 before tax, roughly $600 of that reaches your loan repayment. That matters. If the freed-up cash from an IO loan gets deployed into something productive, IO wins on both cash flow and tax efficiency. If it sits in a transaction account, you have paid a higher interest rate for nothing.
What IO and P&I Actually Mean for Your Loan Balance
With a principal and interest loan, each monthly payment chips away at both the interest owed and the underlying debt. The balance shrinks over the full loan term.
With an interest only loan, you pay only the interest for a set period. Repayments are lower, but the loan balance stays exactly where it started. IO periods are usually 5 years, after which the loan converts to P&I for the remaining term.
That conversion is where the sting sits. Because you have not reduced the principal during those 5 years, the remaining P&I repayments are compressed into a shorter period, and they jump.
The Real Cost Difference: What the Numbers Show
Two worked examples illustrate the trade-off.
NAB case study: A $500,000 loan at 4.39% over 30 years. Choosing IO for the first 5 years gives monthly repayments of $1,829 during the IO period, compared to $2,501/month on straight P&I. That is $672/month in freed cash flow.
But when the IO period ends, monthly repayments jump to $2,748, which is $247 more than the straight P&I option. Total interest over the life of the loan: $434,161 for the IO path vs $400,307 for P&I. The IO route costs $33,854 more in interest.
Home Loan Experts case study: A $500,000 loan at 4.00% over 30 years with 5 years IO costs $32,408 more in total interest than P&I from day one.
At a higher rate of 4.78% on a $500,000 loan over 25 years, the gap widens further: total interest of $440,443 under IO vs $357,766 under P&I, a difference of $82,676.
| IO (5-year period) | P&I (full term) | |
|---|---|---|
| Monthly repayment during IO | $1,829 | n/a |
| Monthly P&I repayment | $2,748 (after IO ends) | $2,501 |
| Total interest (30yr, 4.39%) | $434,161 | $400,307 |
| Extra interest paid | $33,854 | $0 |
Based on $500,000 loan, NAB example.
Those figures look damning for IO. But they measure only interest cost, not total return. If the $672/month cash flow difference is deployed into a deposit on a second property or offset against a non-deductible home loan, the calculus can shift.
Why IO Is Designed for Investors: The Tax Logic
The ATO allows landlords to deduct interest on the loan principal used to purchase a rental property, provided it is rented or genuinely available for rent. Interest on funds used for renovations, extensions, and depreciating assets like air conditioners is also deductible.
Principal repayments are not. The ATO is explicit on this point: you cannot claim a deduction for additional payments made to reduce the principal.
This creates a structural advantage for IO on investment debt. Every dollar of an IO repayment is deductible. On a P&I repayment, only the interest component qualifies. And as you pay down principal, the interest portion of each payment shrinks, so your deductible amount decreases over time.
IO loans do attract higher interest rates than P&I because lenders view IO borrowers as higher risk. But even at the higher rate, the full interest amount remains deductible. For investors in the 37% or 45% marginal tax brackets, the after-tax cost of that interest is significantly lower than the headline figure.
For a deeper look at what you can and cannot claim, see our guides to investment property tax deductions and negative gearing.
The Prepaid Interest Strategy
Investors can pre-pay up to 12 months of interest in advance and claim the full amount as a deduction in the financial year the payment is made.
This is a timing tool. If you have had a high-income year, prepaying June's interest bill forward to 30 June brings forward deductions that would otherwise fall into the next financial year. It does not create new deductions. It shifts existing ones.
If part of your loan was used for private purposes, the ATO requires you to apportion the interest and only claim the rental portion. Run this past your accountant before acting on it.
IO Borrowing Constraints and Portfolio Implications
IO is not available at every LVR. Most lenders restrict interest only loans to 80% of the property value, while P&I borrowers can potentially access up to 95% or even 105% with a guarantor. If you are stretching to a higher LVR, P&I may be your only option.
For investors who can meet the 80% LVR threshold, IO's lower repayments serve a specific portfolio function. The reduced cash outflow allows accumulation of more property while using less of the investor's own capital. Instead of sinking cash into principal reduction on property one, the freed dollars can fund the deposit and holding costs of property two.
One common misconception: IO does not lock you out of voluntary repayments. IO loans allow extra repayments beyond the minimum. The flexibility runs in both directions. You can pay the minimum during tight months and make lump-sum reductions when cash flow allows. This is relevant if you are buying your first investment property and want a safety margin in your budget.
When IO Goes Wrong: The Risks Investors Ignore
IO is a leverage tool, and leverage amplifies losses as efficiently as it amplifies gains.
No equity buffer. If your investment property declines in value during the IO period, you could end up owing more than the property is worth. With P&I, at least part of each payment is building equity that acts as a cushion against falling values.
Repayment shock. When the IO period ends, repayments do not return to what P&I would have been from day one. They are higher, because the same principal must be repaid over a shorter remaining term. In the NAB example, the jump is from $1,829/month to $2,748/month. That is a 50% increase. If rental income has not grown proportionally, the property's holding costs spike.
Refinancing risk. Extending an IO period means reapplying to a lender, and approval is not guaranteed. Lending criteria tighten, serviceability buffers change, and your financial position at year 5 may look different from your position at settlement.
Which Structure Fits Your Strategy?
IO is not universally better for investors. It is better for a specific type of investor with a specific plan.
IO suits you if:
- Your goal is capital growth and portfolio accumulation, not debt elimination
- You will actively deploy the cash flow difference (into offset accounts, additional deposits, or other investments)
- You are in a higher tax bracket where the deductibility of interest payments materially reduces your after-tax holding costs
- You can meet the 80% LVR requirement
P&I suits you if:
- You want to build equity and reduce exposure to market downturns
- You prefer a fixed repayment schedule that does not jump after 5 years
- You are borrowing above 80% LVR
- Your investment strategy is long-term hold with the goal of owning the property outright
- P&I may not be as tax-efficient for investment loans, but it carries less structural risk
The worst outcome is choosing IO without a deployment plan for the freed cash. You pay a higher rate, accumulate more total interest, build no equity, and have nothing to show for the difference. IO is a deliberate leverage strategy. Treat it as one.
FAQ
Is interest only or principal and interest better for an investment property?
Neither is universally better. IO maximises cash flow and tax-deductible interest, making it suited to capital-growth investors who will deploy the freed cash productively. P&I builds equity faster at a lower interest rate, which suits investors prioritising debt reduction and lower long-term interest costs.
How much more does an interest only loan cost over 30 years?
On a $500,000 loan at 4.39% over 30 years with a 5-year IO period, you pay roughly $33,854 more in total interest compared to P&I from the start. At higher rates or longer IO periods, the gap can exceed $80,000.
Can you claim principal repayments as a tax deduction on an investment property?
No. The ATO explicitly states that principal repayments on an investment property loan are not deductible. Only the interest component of your repayments qualifies as a tax deduction.
What happens when the interest only period ends?
Your loan converts to principal and interest repayments for the remaining term. Because the full principal must be repaid over fewer years, monthly payments increase significantly. In one example, repayments jumped from $1,829 to $2,748 per month.
Can you make extra repayments on an interest only loan?
Yes. IO loans allow voluntary extra repayments beyond the required minimum. You are not locked into paying only the interest amount each month.