PRO TIP 🔥
Is your home your long term / forever home?
If not, setting up finance is not as simple as set and forget.
There is a better way to set up your home finance correctly, so you can…
>> maximise tax savings, AND
>> minimise your non tax deductible
There are two type of repayments:
- Principal & Interest repayments
- Interest Only repayments
Typically, you would be making principal and interest repayments toward your Principal Place of Residence (PPOR).However….. what if you intend on converting your PPOR to an investment property and upgrade your home?
If so, you may want to consider if Interest Only repayments could be a better option for you, whilst you maintain an offset account linked to your loan:
>> Build funds in the offset
>> Each month the Interest Only repayment is calculated with reference to the loan minus the offset balance
>> The cash out flow each month reduces
>> You ‘maintain control of your savings
At time of converting your existing home to an investment property, you can withdraw funds from the offset account.
The loan balance stays the same as the original balance, therefore maintaining tax deductibility.
Option 1 – Principal and Interest:
>> You have PPOR debt of $400,000, at 2.8%, and assuming 30 years term
>> Principal and Interest Repayment will be c. $1,644 per month, (includes interest of c. $934 ie Principal repayment of $710 per month (note – the proportion of principal and interest repayment will change over the course of the loan term))
>> As the repayments progress, the principal balance of $400,000 will reduce.
Say in 5 years, you have paid $40,000 of the principal balance, bringing the loan balance to $360,000.
Converting this property into an investment property at that time will mean that your tax deductible loan will be $360,000.
Option 2 – Interest Only
>> you make Interest only payments,
>> $400,000 loan balance, with an offset account attached to this loan
>> The interest rate will be higher for Owner Occupier Interest Only repayments – say 3.36%
>> You will make $1,120 per month in interest repayments, and park the $524 per month in the offset account (note – as the offset account builds up, the outgoing interest repayments will reduce)
>> The interest will be calculated on the loan balance minus the offset account balance
>> Assume over 5 years, you park $40,000 in the offset account.
If you decide to make this property an investment property, you can withdraw the $40,000 from the offset account, which will bring back the loan balance to $400,000. This will maintain the tax deductibility of the loan.
Tax man funds part of your outgoings ………
Having the additional $40,000 as tax deductible means, over the remaining loan term of 25 years, you will be able to claim tax deductions for the interest incurred. Assuming a 25 year Principal & Interest term remaining (unless the loan was restructured – which should be considered!), the total interest payable at 3.36%, will be $19,178 over 25 years. At a tax rate of 32.50%, the Taxman will fund $6,232.85 of this interest, costing you $12,952.15.
At the same time, you would have put an extra $40,000 cash deposit toward your new home, ie $40,000 less borrowing. The $6,232.85 could also be re-directed toward your owner occupier property.
Conclusion
There are pros and cons of both approaches.
OPTION 1 – Where you wish to buy another PPOR, under Option 1, you will either need to borrow the $40,000 back from the bank or sell the property to get access to cash. Where you borrow the $40,000 back from from the bank, this will be a non-deductible loan.
OPTION 2 – Interest only payments is a great option where the property is not your forever home, as it allows you to maintain tax deductibility of the loan. However, with interest only, it is good to be disciplined with building up your offset account balance.
Disclaimer:
- The above should be considered keeping in mind that Interest Only rates are higher than Principal & Interest rates.
- Note – the above example used is generic, and is not a substitute for appropriate income tax and credit advice.
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