Prin­ci­ples of in­ter­est

The Sunday Times - - BUSINESS WEEKLY - Noel Whit­taker

I HAVE writ­ten be­fore about the chal­lenges that can arise from the banks’ re­cent prac­tice of mov­ing bor­row­ers from in­ter­est-only (IO) loans to prin­ci­pal and in­ter­est (P&I) loans on in­vest­ments.

While it may be pos­si­ble in some cases to main­tain the sta­tus quo by chang­ing banks, or by do­ing some ro­bust ne­go­ti­a­tion, these op­tions are not avail­able to ev­ery­one.

So, let’s think about ways we can turn that lemon into lemon­ade. The key here is that IO loans are cur­rently priced about 50 ba­sis points higher than a P&I loan, so by mov­ing to P&I you are sav­ing in­ter­est.

As­sume you have an in­vest­ment loan for $400,000 on an in­ter­est-only ba­sis at 5.5 per cent. The monthly re­pay­ments would be $1833, wholly taxd­e­ductible, and at the end of the term you would still owe $400,000. Now, let’s sup­pose the bank nudged you into a P&I loan over 30 years at 5 per cent for that $400,000. Your re­pay­ments would rise to $2147 a month, con­sist­ing of $1667 of in­ter­est and $480 of prin­ci­pal.

The good news is, you are sav­ing in­ter­est; the bad news is you are grad­u­ally los­ing part of the tax de­ductibil­ity.

How­ever, even though in­ter­est is tax-de­ductible, wouldn’t you rather be pay­ing $1667 in­ter­est a month than $1833?

Most in­vestors are in the 34.5 per cent tax bracket when Medi­care is in­cluded. This means you are pay­ing 65.5 per cent of the in­ter­est, while the gov­ern­ment is pay­ing just 34.5 per cent of it.

Some in­vestors com­plain that fall­ing in­ter­est rates mean they lose tax de­ductibil­ity.

I al­ways of­fer to re­fi­nance the loan for them at 25 per cent — this would re­ally max­imise their tax de­duc­tions — but I haven’t had a taker yet.

Now, let’s fast for­ward 10 years. If in­ter­est rates re­main un­changed, the IO bor­rower will still owe $400,000, while the P&I bor­rower will have re­duced their loan to $325,000.

The P&I bor­rower has made a hefty re­duc­tion in the prin­ci­pal, and cre­ated a big safety buf­fer if in­ter­est rates rise.

Now, let’s re­fresh our knowl­edge of why in­tere­stonly loans, or very long-term loans, are best in cer­tain cir­cum­stances. If you have a loan on your res­i­dence, as well as an in­vest­ment loan, it’s a no­brainer to have the in­vest­ment loan on the long­est term pos­si­ble so as to max­imise the amount of money you have avail­able to quickly pay off that home loan. If you can’t get an IO loan, go for a 30-year one.

An­other com­mon sit­u­a­tion is when a per­son aged 55 or more still has a home loan, which they hope to have paid out by age 65 when they re­tire.

Re­pay­ments can be crip­pling on a P&I loan that has only a 10-year term. A bet­ter op­tion would be to leave the home loan on the long­est term pos­si­ble, and max­imise the amount con­trib­uted to su­per­an­nu­a­tion via salary sac­ri­fice.

This turbo-charges the su­per, with the aim to with­draw a lump sum at re­tire­ment to pay out the home loan.

Con­tin­u­ally chang­ing rules mean that man­ag­ing your money is not a case of set and for­get. Noel Whit­taker is the au­thor of Mak­ing Money Made Sim­ple. His ad­vice is gen­eral in na­ture and read­ers should seek their own pro­fes­sional ad­vice be­fore mak­ing fi­nan­cial de­ci­sions.

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