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Making Debt Work For You
The Age
Monday March 3, 1997
Ross Greenwood looks at how you can save thousands of dollars in taxes by juggling home and investment loans using an interest capitalisation strategy.
AT THE moment, it seems everyone is seeking ways to reduce their home mortgage more quickly. It could be because of the large debts some people have got themselves into in the past few years - or the paranoia of holding such a large debt for a long time.
There is also perhaps the gut feeling that if house prices are not moving quickly, the rise in the value of the house is not covering the cost of the interest.
All sorts of schemes and devices have been created to help people pay off their home loans more quickly.
The advent of mortgage calculators made people quickly realise that fortnightly rather than monthly payments have a noticeable affect. The reason? You make one additional mortgage payment each year.
Also, people found that by automatically increasing their repayments each year, the term of the mortgage could fall by 10 years or more. Again, the simplicity of this is that by increasing your repayments each year you are repaying the principal of the loan more quickly.
People, however, are quick to recognise the nuances of the Tax Act. The simplicity of this is that the interest on an investment loan is tax deductible; the interest on your principal place of residence is not. But this second rule, relating to your home, does not always prove true.
For example, if you can arrange your financial affairs so you rent the home from another entity - for example, a unit trust or a company - you may be able to make your home loan tax deductible. The downside is that the trust or the company will have to pay capital gains tax on the after-inflation profits when you sell.
The other tactic being used with a home mortgage and an investment loan is to repay the home mortgage as quickly as possible while allowing the investment loan interest to accumulate.
This is by using a business tactic known as interest capitalisation.
A good example of this is a person on the top tax bracket of 48.7 per cent with a $200,000 home mortgage and a $100,000 investment property loan.
A person might pay 6.95 per cent (variable) over a 25-year period for the home loan and a higher rate (we have assumed 8.05 per cent) for an investment loan. Some lenders will charge the same interest rates for investment loans and their basic home loans.
So let's calculate what happens if the investment loan and the home mortgage are both at 8.05 per cent.
The principal and interest payments on an 8.05 per cent $200,000 25-year home mortgage are $1550.26 per month. The repayments on a $100,000 investment loan on the same terms are $775.13 per month.
But if the total repayment of $2325.39 is directed to the home mortgage each month, the home loan will be paid off in 10.73 years - or more than 14 years early.
The interest component of the investment loan has been capitalised - therefore this balance has blown out from $100,000 to $233,906 before the home mortgage has been paid off.
However, it has also given you an extra $165,788 in additional deductible interest over and above what you would have been entitiled to under the standard financing. For a top tax payer this equates to potential tax savings of $80,736.
To get rid of the remaining debt, once the home mortgage is paid off you direct the repayments to the investment loan at $2325.39 per month.
It should also be observed that because the investment property might have a loan balance significantly greater than the value of the property, once you have paid off the home loan your lender is likely to retain both the home and the investment as security. This will depend on the growth in value of the home and the investment.
The worst-case scenario in this situation is if the investment property falls in price during the period you own it. This could mean the term of the loans needs to be extended or - if you wish to unwind the whole arrangement - that a residual loan needs to be taken out against the home.
According to the bank monitoring group Cannex, only a few lenders offer formal structures to provide customers with this strategy.
Among those that do are the State Bank of New South Wales' Veridien service (though technically this is a line of credit), Access Home Loans, Advance Bank's Portfolio Loan, Austral Mortgage Corporation's Wealth Optimiser), MLC and Westpac's Income Maximiser.
One of the first to offer the service was Sydney-based Austral Mortgage Corporation, which provided the examples in the accompanying tables.
According to Guy Edema, of Austral, one of the greatest risks anybody takes with this strategy is that the Australian tax office might issue a ruling that stops people from claiming tax deductions on capitalised interest. Conversely, capitalising interest has been something large companies have done from time to time to suit their cashflow purposes.
Mr Edema told Money: "There has been no ruling on it but we have an opinion on it from lawyers Gadens Ridgeway. It was an opinion on the structure and the documentation which we are making freely available."
Mr Edema said it is understood a growing number of investors are seeking private rulings on such arrangements.
"We were promised something prior to Christmas and they said that the matter has gone to a taskforce looking at negative gearing," he said.
While acknowledging that there is a risk the tax office might clamp down on such schemes, Mr Edema says people can simply revert both their investment and their home mortgages back to standard variable loans.
Cassandra Williams, from Cannex, says that broadly the schemes offered by the different institutions are similar, though she notes that with the Advance Portfolio Loan, people can divide their assets and liabilities into many sub-accounts, some of which can be kept in credit if you wish.
THE BENEFITS OF CAPITALISING INTEREST
* You pay out your home loan portion number the Wealth Opitmiser structure in 120 months compared with 300 months under standard financing.
* You potentially obtain $165,788 in increased deductible interst, over and above what you would have been entitled to under standard financing should the loan extend to the full term.
* Wealth Optimiser structure may provide you with potential tax savings of $80736, if those savings are applied as principal repayments it will reduce the term of the Wealth Optimiser loan accordingly.
THE BENEFITS OF CAPITALISING INTEREST Standard Loan A (Home) Amount $200,000 Years 25 Interest 8.05% Repayments 1550.26 Wealth Optimiser Loan A (Home) Amount $200,000 Years 25 Interest 8.05% Repayments (First 10.73 years) $2925.39 Standard Loan B (Investment) Amount $100,000 Years 25 Interest 8.05% Repayments $775/13 Total $2325.39 Wealth Opitimiser Loan B (Investment) Amount $100,000 Years 25 Interest 8.05% Repayments (First 10.73 years) $0.00 Repayments (Last 14.27 years) $2325.39 Marginal Tax Rate 48.7%
© 1997 The Age
