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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. Like with most things in life there are multiple factors to consider when working out what best is for you.
Blogger: David Johnston, founding director, Property Planning Australia
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 actually develop a property plan for your future changes in circumstances. This planning will impact the way you structure your home loans.
Let’s break down some of the key factors that it’s important to understand –
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 - Deductible debt is when you have borrowed for investment or business purposes and therefore can claim the interest as a tax deduction. 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 than 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.
4. Purpose Test - We only have one opportunity to borrow to purchase an asset. That is when we first purchase the asset. That means we cannot redraw on a loan that we have paid down and expect to claim the interest on the redrawn money in relation to the purchase of the original asset. This is because the redrawn funds will go towards a different expense to the original asset. In short, the ‘purpose’ that you spent any borrowed or redrawn money on determines whether the interest is deductible. (people often get confused by this point so I may expand on this in a future blog)
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 effectively additional repayments (that otherwise would have gone directly into the loan account) into the offset account. This achieves exactly the same result as paying down the loan in terms of reducing your monthly interest. The key distinction is that your loan debit balance is not reducing and your savings credit balance is increasing.
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 existing home loan 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 – It’s always worthwhile planning for some flexibility into your finance strategy if possible. One way of doing this is by choosing to pay interest only on a loan and placing your additional repayments into an offset account. You are then 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.
For many people, it is necessary to have ‘forced’ repayments. Otherwise they will 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 can work here too. However it should be treated as an off limits account, just the same as you would consider your redraw funds if the money was going directly into the loan.
The key point to understand is how powerful an offset account can be to your loan structure. The psychological adjustment and challenge for some people is to appreciate that making additional repayments into the offset can be viewed the same as paying those same dollars into the loan account itself.
Having spoken to many hundreds of people about their lending, spending and banking habits I’m 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 ensuring that you have a clear understanding of your future property plan and remembering that there is more to your loan structure than the interest rate!
Interest is the amount of money charged by a lender or financial institution for a loan, which is calculated as the percentage of the principal amount paid over the loan term.