Should I pay interest only or principal and interest on my loan?
This is an age-old question that seems to be asked by every second person I speak to about their finances. As with most things in life, the factors to consider are multi-faceted rather than one dimensional. I want to explore the somewhat “controversial” loan structure that shows it can actually pay to have all your loans set up as interest only repayments.
General Principles of Interest Only vs Principal and Interest
Let me begin by saying that as a general rule, reducing the interest payable on your debt is almost always a good idea. Just like saving money is basically always a good idea.
Where the answer to the repayment approach question gets confusing, is when you start to develop a property plan for your future changes in circumstances. This planning could impact your loan and banking structure.
Key factors to plan around
1. Debt/interest reduction
We always want to reduce the interest payable on our debt. Note, that I don’t suggest reducing the loan balance or debt itself. This is a key distinction.
2. Prioritise reducing non-deductible debt
If we have deductible and non-deductible debt, we want to put all spare cash flow towards reducing the interest payable on the non-deductible debt. This is because the non-deductible debt is effectively more expensive as we cannot claim any of the interest as a tax deduction.
3. Separate deductible and non-deductible debt
We want to keep non-deductible and deductible debt separate – so we can focus on reducing the non-deductible debt. If the debt is combined into one loan account, then any reduction is equally apportioned from an accounting perspective. This means you are unlikely to be maximising your tax deductions and reducing your non-deductible debt as rapidly as possible, as per point 2.
4. Purpose Test
We only have one opportunity to borrow to purchase an asset. That is when we purchase the asset at the start. That means we cannot redraw on a loan that we have paid down and expect to claim the interest on that debt relating to the purchase of the original asset. The redrawn funds will not go towards purchasing the original asset as you purchased it in the past. Therefore the funds you redraw are actually going to be used towards something else. (people often get confused by this point)
5. Offset Accounts
The functionality of offset accounts can provide you with the maximum flexibility and the best of both worlds. This can allow you to pay interest only on a loan and still make additional repayments (that may have gone directly into the loan account) into the offset account. This achieves exactly the same result as paying down the loan.
6. Home becoming an investment
Is there is any chance the home you own currently will ever be an investment property in the future and you will purchase a new home? By paying interest only on the loan and placing all the additional repayments into an offset account you are building cash that could be used towards a future home purchase. You also will not have paid down your loan on the existing home which could provide you with the maximum tax deductions on that debt when it becomes an investment. If you had paid this debt down you would only be able to claim the interest deductions on the reduced balance. (see point 4)
7. Purchasing a home in the future
If all your debt is currently tax-deductible, is there any chance you may purchase a home in the future? If there is, once again you want to have as little interest payable on the future home as it will be non-deductible debt. Therefore you should build up your savings/additional repayments in an offset account to be used towards purchasing the future home. This will minimise your non-deductible debt at that point and ensure that you have maintained the same level of tax-deductible debt.
8. Flexibility/buffer
This relates to choosing to pay interest only on a loan and placing your additional repayments into an offset account. You are provided with flexibility should your circumstances change as per point 6 & 7. You are also building up a buffer of savings which can provide you with a safety net should you have some unexpected bills or expenses.
Manage your discipline
The psychological mindset adjustment and challenge is the realisation that making additional repayments into the offset is the same as paying those same dollars into the loan account itself. For many people, it is necessary to have ‘forced’ repayments. Otherwise they will just spend the extra money. For those people it is a good idea to set up a separate savings account for their day-to-day banking. This maintains a barrier to ensure better money management. The offset account should be an off-limits account, just the same as you would consider redraw if the money was going directly into the loan.
Having spoken to many thousands of people about their lending, spending and banking habits we are acutely aware of the complexities. Setting up the right loan structure is partly about gathering all the information, partly about properly understanding the information, and most importantly about being comfortable with the set up you select that suits your future property plan.
