A structure that saved this client $140,000
Anyone that has (or will have) a home loan and tax deductible expenses (e.g. investment loan interest) must read the following case study.
The case study provides an example of how we have structured a client's loans so that they repay their home loan at a much faster rate. They are projected to save over $140,000 in interest and repay their home loan in full in just over 6.7 years (compared to 12.3 years which is what they would have achieved without our advice).
If you would like to investigate if this 'Repayment Flexibility' loan structure would be appropriate for you, please contact us indicating your interest and one of our Advisors will be in contact.
Case study: How Lilly and Daniel will repay their $582,000 home loan in 6.7 years and save $140,000 in interest
Lilly and Daniel approached us as they wanted some advice on how they could own their home sooner so they could invest further. Lilly was concerned about the level of their home loan and, despite all their efforts to repay it quickly, the balance wasn't reducing fast enough (for her). Lilly wanted to know if they should sell their investment property and use the sale proceeds to repay most of their home loan (although Daniel wasn't keen on that idea because the investment property had performed very well - strong capital growth and zero vacancy).
Lilly and Daniel's financial details are:
- Lilly's income: $110,000 p.a. before tax
- Daniel's income: $89,000 p.a. before tax
- Home loan balance: $582,000 (home is worth $1.2 million)
- Investment loan: $550,000 (investment property is worth $1.1 million)
- Net rental income (after expenses excluding interest): $33,000 p.a.
- Surplus income (after paying for everything including living expenses): $24,000 p.a. after-tax (this currently being directed into the home loan as extra repayments).
Currently, they are making interest only repayments on their investment property loan (net rental income pays for most of these repayments and they contribute approximately $5,500 from their salary income). They are also making the minimum principal and interest repayments on their home loan of $46,500 p.a. plus any surplus income - currently $24,000 p.a.
Our solution: we suggest that they don't make any repayments on their investment loan. Instead, allow the interest to be added to the loan. This will allowed them to direct all income including rental into repaying the home loan. Therefore, home loan repayments will be the minimum of $46,500 plus net rental income of $33,000 plus the $5,500 that was previously being directed into the investment loan plus surplus income of $24,000 ($109,000 in total). We call this the 'repayment flexibility structure' because it provides you with the flexibility to direct all repayments into one account (the home loan). Remember, the amount of repayments is not changing - it's just that they all go into one account.
This is what will happen in the first year:
Home loan
Opening balance $582,000
Plus interest $38,500
Less repayments $109,000 (per above)
Closing balance $511,500
Investment loan
Opening balance $550,000
Plus interest $38,500 (added to the loan)
Closing balance $588,500
At the end of the year the total debt is $1.1 million ($511,500 + $588,500) compared to $1.132m at the start of the year. Total debt has reduced. The other benefit of this structure is that the clients now have proportionally more tax-deductible debt and less non-deductible debt. Each year the clients home loan will reduce at an accelerated rate in return for their investment debt increasing. For example, by year 5 their home loan will be $174,000 and investment loan will be $780,000. This will result in higher negative gearing benefits - i.e. less tax payable.
In 80 months (6.7 years) they would have repaid their home loan in full. By this time, their investment loan will be $875,000 (because of the accumulated interest). This debt can now be solely secured by the investment property alone which means that they will fully own their home (unencumbered) with no debt. They'll safely hold the title, not the bank which is exactly what Lilly wanted.
Under the traditional structure (i.e. what they were doing before our advice), it would have taken the client's 148 months (over 12.3 years) to repay their home loan. This means they would have paid over $140,000 more interest (from after-tax income)! Lilly and Daniel would have had to earn over $230,000 pre-tax to have met this (after-tax) interest cost. That's a huge saving in anybody's language.
In 6.7 year's time, the clients can either concentrate on repaying the investment loan or invest their surplus cash (e.g. maybe buying another investment property).
Important considerations prior to implementing this structure
- The loan structure and loan products used must be carefully selected and structured to ensure that all tax considerations and rules are addressed. Incorrectly structured lending could result in a deduction being denied and/or penalties being imposed. Not all lenders offer the required products or structures.
- Disciplined cash flow management is an absolutely critical requirement before this structure can be implemented as poor cash flow management may result in a reduction of net worth. Be realistic about your cash flow management abilities (and history) before implementing this structure.
- It is important that the sole or predominant purpose for implementing any loan structure is not to obtain a tax benefit. Therefore, it is probably wise to document the predominant reason for adopting this structure (maybe similar to Lilly and Daniel) to avoid any confusion. Not doing so may risk triggering anti-avoidance provisions which may result in breaching the tax rule (possibly resulting in financial penalties).
- It may be appropriate to seek advice from your accountant and/or financial advisor before implementing any credit advice to ensure that it's appropriate for your circumstances. The structure discussed in the case study above may not suit everybody.
Resources use to delivery this advice
The resources relied upon in developing the above credit advice includes:
- Tax Determination issued in 2008 (TD 2008/27) which confirms that the well-known Hart case in fact confirmed that capitalised interest is in fact tax-deductible (i.e. unpaid interest added to the investment loan balance each month).
- Private Ruling in respect to the 2007 financial year (PR 69725) which confirmed the ATO's view on a taxpayer capitalising interest on an investment loan to maximise cash flow to allow them to repay their home loan at a faster rate (i.e. similar to the above case study). We acknowledge a private ruling only applies to the taxpayer who applied for it. However, it does indicate how the ATO views certain arrangements.
Where to from here?
If you would like to investigate if this 'Repayment Flexibility' loan structure would be appropriate for you, please contact us indicating your interest and one of our Advisors will be in contact.
Contact us today on 1300 880 224 (+61 3 8624 4600) or click here for all our contact details.
