How much time did you invest in determining whether you will make interest only or principal and interest repayments on your mortgages?
If you are like most people, the answer is just a few minutes and the conversation is usually limited to paying off extra if you have a home loan, and possibly paying interest only for investment debt so that you can claim the interest as a tax deduction.
Unfortunately, most borrowers and indeed mortgage professionals don’t realise that their repayment strategy can have a huge impact on wealth creation over their lifetime, as well as significantly affecting their ability to manage risk.
Adding insult to injury, usually you cannot undo the damage of a poor mortgage strategy – you can only fix it once you become aware of and repair the damaged structure.
On the plus side, if you have an effective repayment strategy, you can enjoy the positive benefits to your hip pocket as well as piece of mind, such as:
- Being able to accumulate and hold property.
- Optimising existing tax deductions.
- Preserving potential future tax deductions.
- Growing your savings at a faster rate while at the same time reducing interest payable.
- Minimising the amount needed to borrow for a future home purchase.
- Enhancing your money management system.
- Ensuring you pass the Purpose Test and claim deductions incorrectly.
- Managing risk.
- Perhaps most importantly, improving your mental health and well-being through effective financial management.
So how can consumers educate themselves to get their repayment strategy right, given the complexity and detail required to implement it effectively?
Let me show you how.
Optimising investment deductions
In the last couple of years, interest rates on investment loans have become more expensive than home loans. Further, if you select interest only (IO), you also pay an added premium on the rate as opposed to opting for principal and interest (P&I).
Significant changes followed on from the Australian Prudential Regulation Authority’s (APRA’s) regulatory interventions as they attempted to take the heat out of the property market in 2016 and 2017. In this case, their approach was to put the squeeze on investors by making it more expensive to borrow and pay interest only.
As a result, many people blindly opted to make principal and interest repayments, and make additional repayments into the loan, without first establishing whether this mortgage strategy is the best for them in the short and long term.
In many instances, this decision is actually costing those people more money today and potentially more into the future.
Many borrowers and mortgage professionals do not properly understand why this is the case so we will explain.
When claiming interest deductions today on investment debt, you are effectively reducing the true cost of the debt – as measured by the interest rate– to make it lower than that of your home loan, even though the nominal rate charged by the lender is higher.
This is why, in most instances, if you have tax-deductible investment debt and non-deductible debt on a home- or consumer-related debt, it will make sense to pay interest only on the investment debt. Because, after your tax deduction, the effective interest cost is lower than that of your home loan.
Here are two examples to illustrate this idea.
Home loan vs investment loans, P&I vs IO
Home loan P&I – 3.20%
Home loan IO – 3.50%
Investment P&I – 3.60%
Investment loan I0 – 3.70%
True interest rates cost
Interest only AND investment loan rate 3.70% less 32.5% tax deduction = true rate 2.5% approximately
P&I AND home loan = 3.2%
The true interest rate cost on your investment loan is significantly lower than what you pay on your home loan.
Here is an example of how it works in practice when completing your tax return factoring in the tax deductions on an investment property, importantly including the interest deduction.
- Salary = $90,000
- Rent = $20,000
Total income is $110,000
Property deductible expenses:
- Repairs, maintenance, utilities etc $5,000
- Interest expense is $15,000.
Taxable income $90,000
The $15,000 interest expense reduces your tax bill by $15,000 x 32.5% tax rate = $4,875 saving pa.
Not only, does this make the true interest rate lower, this tax savings can compound over years and decades if you get your mortgage strategy and your repayment strategy right.
Even if you own an existing home that you plan to upgrade, your repayment strategy can play a major role in your ability to be able to hold the asset as you transition it to an investment property.
Preserving future deductions to hold property as you accumulate
The goal here is determined by your future plans to purchase a future home or have any other major non-deductible expense such as renovating. This strategy will:
- Provide you with the greatest opportunity to claim future tax deductions should your current home become an investment property in the future.
- If you only have investment debt and plan to purchase a home later on, build up your cash savings while preserving future deductions meaning you will have the dual benefit of needing to borrow less for your future home.
This mortgage strategy is not well known because it is complex to understand and explain. For this reason, many mortgage professionals do not understand it and, among those who do, some will not bother to take the necessary time to educate borrowers on the potential long-term benefits.
In such instances you would select interest only, or the minimum principal and interest repayment on your loans, and use an offset account as your repayment account rather than paying directly into the loan itself.
In this way, you preserve your ability to claim the maximum future interest tax deductions while also building up a cash buffer to minimise the amount of interest payable on your future home.
This method, like many repayment strategies, is completely counter-intuitive to what we are taught growing up: that is, we should pay down our debt. This natural instinct often means that borrowers will not remain open minded to these kinds of strategies due to ingrained beliefs about debt reduction.
This is why considered education with a strategic mortgage broker is vital.
It is also why the offset account is so powerful. You can only get the best of both worlds by reducing the interest payable in exactly the same way as if you paid down the debt, while preserving tax deductions, building up cash savings and, in so doing, maximising the likelihood that you will pay less interest on your future home and be able to hold your existing properties through the use of an offset account.
You achieve all these advantages through not reducing the balance of the loan at all, or reducing it only minimally if you select principal and interest. For more detail on this strategy, we have previously dedicated a full article to it on “How to turn your first home into an investment property when upgrading.”
Growing the war chest!
Selecting the interest only strategy allows you not only to optimise your tax deductions, but also to place all your surplus savings and cash flow towards paying down your non-deductible debt or crediting it into your ‘Grow’ offset account that you do not touch.
Studies have found that one of the biggest causes of stress is money – or, more precisely, by our inability to organise and manage our money. So, it should come as no surprise that the amount of available funds you have in the bank correlates directly with your happiness.
With this connection in mind, it makes good sense to manage risk and optimise your monthly surplus cash to grow your savings faster. You can achieve this through a considered repayment strategy – which necessarily involves maximising the amount of money left over at the end of each month after you get paid and all of your expenses are accounted for.
This is your ‘net monthly surplus’, which you can then put towards increasing your savings, preferably in your offset account, paying down your debt or investing.
Despite our natural instincts, this can be a reason to opt for a repayment approach of paying only the minimum principal and interest repayments and placing all your surplus funds into what we call your ‘Grow’ or ‘Repayment’ offset, or even opting for interest only, depending on the situation and your personal preferences.
Which repayment strategy is right for you?
Principal and interest strategy
Opting for principal and interest repayments provides a form of forced repayments that will be directly credited onto the loan and that you will not be able to access. This repayment approach is appropriate if you lack discipline with your spending habits, you are certain you are living in your final home, you will never take on non-deductible (bad) debt again, or you will not take on any debt of any form again.
Each month you are actively reducing your loan balance and this reduction is non-negotiable. You will not have redraw access to the minimum required principal repayment that you repay because you ‘must’ repay the minimum in line with your loan contract.
In contrast, if you chose interest only repayments, for example, any principal paid into the loan or kept in your ‘Grow’ or ‘Repayment’ offset is still accessible or will all be available in redraw.
With the P&I strategy, you can also make additional repayments into the loan above the minimum principal that are likely to remain available if you have access to redraw.
Interest only strategy
As we’ve explained, interest only or the minimum principal and interest repayments can be a positive strategy if you want to maximise existing tax deductions, focus on paying down non-deductible (bad) debt, preserve future tax deductions such as for a home that you would like to turn into an investment. It can optimise your ability to hold property, reduce the amount you need to borrow for a future home and grow your savings balances at the fastest rate possible to manage risk and invest.
With interest only repayments, you have an increased net monthly surplus. Of course, it makes no sense taking this route if you’re the kind of person who has difficulty saying “no” to impulse purchases and likely to spend the surplus frivolously – in that case principal and interest may be the option for you. But if you are goal driven and skilled at managing your money, you could consider interest only or the minimum principal and interest as an option.
Your choice of either principal and interest or interest only repayments will have a large impact on your net monthly surplus. For example, our clients Geoff and Katherine applied for a home loan of $800,000 and had built up savings of $50,000. On principal and interest repayments, they would be making monthly repayments of $3,372. In contrast, on interest only they pay $2,500 each month. That’s a difference of $872 each month – or $10,464 each year. That can build up your savings buffer faster, be used for investing to go towards a future home which will then have less debt on it and preserve the original loan balance that remains to optimise future tax deductions whilst being offset currently.
When you boil it all down, the choices are reasonably simple. You can make either interest only or principal and interest repayments.
What is complex is:
- Understanding the benefits of the different strategies, especially given some of those benefits might be worth nothing today but could produce thousands or millions of dollars for you in the future through property holding, acquisition and deductions
- Staying disciplined with your repayments and savings.
As with most of the hundreds of mortgage strategies that you can use to create wealth, one key ingredient is to use the almighty offset account so you can still repay debt as fast, just not directly into the loan itself. As we keep saying, the offset is the bank’s greatest invention, and paying down debt is a great idea, it just doesn’t have to be directly into the loan itself!
If you’d like to discuss your property plans or mortgage strategy, please get in touch with us here.