How to manage home loans
Interest offset accounts
Superannuation and home loans
Prioritise repayment of the most expensive loan
Just leave it
Chapter 1 - Home loan debt and how to manage it
Home loan debt is debt incurred on buying, maintaining or improving a home. Home loan debt is usually not that expensive, since the loan will be secured by mortgage over the home, and this means there is relatively little risk for the lender. Rates are currently about 5%.
Home loan debt is easily the most common form of personal debt in Australia. It accounts for more than two-thirds of total personal borrowing. The interest rate on home loans is usually lower than the borrower could achieve for other types of debt because the lender typically takes a mortgage on the home. A mortgage is a form of security arrangement that gives the mortgage holder (the lender) the right to order that the asset be sold in the event that the terms of the loan agreement are not met. Because of this right, the risk to the lender is less than it would be in other cases. Consequently, the lender is happy to accept a lower rate of return from the borrower.
Please have a look at this simple but useful video from the folks at Investopedia, which gives a good general description of a mortgage:
Sometimes, people assist other people to undertake a home loan. For example, parents may allow their children to use the parental home as security for a home loan. This is known as guaranteeing the loan. This type of borrowing is included within the range of owner-occupied borrowing.
Home loan debt is not tax deductible: it is not incurred for the purpose of producing assessable income and it is inherently private and domestic in nature. This means you have to earn more than $1 for every $1 of home loan interest that you have to pay. If your marginal tax rate is 30%, for example, then you have to earn $1.42 in order to pay $1 of interest to the lender (after you pay $0.42 in tax). Thus, a 5% home loan rate becomes the equivalent of 7.14% pre-tax for someone in the 30% tax bracket. The pre-tax rate is higher if you are in a higher tax bracket. That’s expensive money.
This is why everyone should aim to pay off their home loans as quickly as possible. Making repayments on a 5% home loan is the same as earning up to 7.14% capital guaranteed, adjusted for tax. For the level of risk (nil), that’s easily the best investment you will ever make.
The following sections discuss various strategies for best managing home loans. We recommend that you speak to us before you implement any of them, as they often require you to do some other things correctly as well. But the main objective is the same throughout: minimise non-deductible interest on your non-deductible home loan.
Ways to manage home loans
INTEREST OFFSET ACCOUNTS
Interest offset accounts (IOAs) are a particularly useful type of savings account. They are a standard savings account, but they are linked to a home loan. The balance of the home loan on which interest is charged is reduced by the amount within the IOA.
For example, if you owe $150,000 on your home loan, but have $50,000 in an IOA, then you will only pay interest on $100,000. Effectively, then, the rate of interest paid on the $50,000 is the same interest rate as you are paying on your home loan. This will be higher than the interest you would receive for any comparable type of investment.
This short video made by the Yorkshire Building Society explains how they work (just remember to convert from pounds to dollars!):
Interest offset accounts should be considered (and probably used) by virtually everybody with a home loan – at least, everyone who is ahead on their loan repayments. This is because when you put money in an IOA it is as if the amount in the IOA has actually been paid off the home loan. But it actually hasn’t. The money in the IOA can be accessed the same way that your normal savings can. This is usually much easier than redrawing on a home loan.
Parents, for example, who might be thinking of sending their kids to a fee-paying private high school might choose to save into an IOA rather than make extra repayments onto their home loan. This makes things as easy as possible when it comes time to pay the fees: the parents simply use their savings. The alternative, in which parents make extra repayments into their home loan, would require the parents to redraw money from the loan each time they needed to pay a school fee. At the very least, this is a hassle. It can also involve fees and charges, and a lender might even refuse to allow the redraw if the parent’s situation has changed (if one loses a job, for example).
IOAs are often used by families to help out younger members who are buying a first home. In a simple example, mum and dad (in their fifties or sixties) agree to let their kids use their own savings money to offset their son or daughter’s loan account. Mum and dad might be giving up a small interest benefit for themselves, but their son or daughter get a much larger one.
For example, the ANZ currently pays 0.5% interest on its premium cash management account, for amounts up to $100,000. So, if mum and dad have $50,000 sitting in a savings account, they will be earning just $250 a year in interest. (That interest is also taxable if mum and dad are taxpayers). If their adult son or daughter has a standard ANZ home loan, the interest rate is around 5.2%. So, if the $50,000 is used to offset the kids’ home loan, the kids save $2,600 in interest each year. And, of course, if the kids pay tax at 30%, then they need to earn more than $3,700 in order to pay $2,600 in interest.
Putting the $50,000 into an offset account earns an effective pre-tax amount of $3,700. This is easily the best return available for that $50,000. The son or daughter could even pay the parent $250 (or something more) to reimburse them for their lost income – and still be more than $2,300 better off.
There does need to be some caution: the savings account will need to be in the daughter’s name, and so it would make sense for there to be a loan agreement in place between the daughter and her parents. But this is quite easily managed and it is easy to give mum and dad plastic cards that allow them to access the money without needing to involve their daughter.
So, if you or someone you love has a loan, you should consider an interest offset account.
SUPERANNUATION AND HOME LOANS
Ultimately, private housing must be bought using after-tax dollars. The deposit used to purchase a private residence, for example, must be saved after tax is paid on the purchaser’s income. The principal and interest payments on the loan must also be paid out of after-tax income. Ultimately, the whole property is paid for after-tax.
Because of this, people who face lower tax rates require less pre-tax income to buy the same amount of house. The following table shows how much pre-tax income is required to buy a $500,000 property, when various marginal tax rates apply.
What this table shows is that the same property does not cost the same amount for people with different marginal tax rates. A person paying no tax only has to receive $500,000 to buy a $500,000 property. A person paying tax at a marginal rate of 45% has to earn more than $900,000 to buy the same property.
Have a particular look at the second row. This is the 15% tax rate this is payable on deductible super contributions into a super fund. The point of the table is this: if families make deductible super contributions into someone’s super fund, and then withdraw these contributions tax-free when the relevant person reaches the age of 60 and use it to pay for repay the home loan, the family only need to earn $588,000 pre-tax to buy the $500,000 property.
So, in many cases, and especially if you are approaching the age of 60, it makes sense to increase super contributions rather than repaying your home loan. In that case, you would make paying off the home loan a retirement goal.
By the way: this strategy is one that ASIC itself encourages. They even provide a “Super vs mortgage calculator” where you can assess whether to pay off a home loan or make increased super contributions. Click on the graphic to visit the site.
PRIORITISE REPAYMENT OF THE EXPENSIVE HOME LOAN
As we saw above, for taxpaying borrowers, home loans are actually more expensive than the interest rate suggests. This is because the home loan is used for a private purpose, and it is therefore not tax deductible. This means you have to pay tax before you pay interest. For someone in the 30% marginal tax bracket and paying 5% interest on their home loan, the effective pre-tax interest rate becomes more than 7%.
In contrast, if a loan is used for a deductible purpose, such as buying an investment property, then the interest is deductible. The interest rate paid to the lender is the same as the effective after-tax rate. The effective after-tax rate is therefore often cheaper on the investment loan.
So, a home loan is generally more expensive than an investment loan. This means that you should prioritise repaying the home loan wherever possible. A simple way to do this is to make sure you use your deductible debt facility to pay any expense that that facility is appropriate for. For example, council rates for an investment property can and should be paid using the deductible debt facility.
Using debt to pay as many of these expenses as you can will free up as much of your cash flow as possible. This freed up cash flow should be used to retire your non-deductible debt.
In this way, every extra dollar that you draw on your deductible debt will be offset by the repayment of an extra dollar of your non-deductible debt. You borrow a dollar on one loan and repay a dollar on the other loan. The total debt will not be increased, but the mix of debts will have changed. The less expensive debt will be larger than it would have been otherwise; the more expensive debt will be lower. This means that your total debt has become cheaper.
Remember: the deductible debt can only be used to pay expenses that are appropriate to be paid using that debt facility – basically, debt used to acquire or manage income-generating investments. It cannot be used for private purposes.
AMP refer to this as ‘debt recycling’ and you can read their thoughts on it here. As it happens, ‘debt recycling’ is a misnomer. The debt is not recycled. One debt is removed and another is created. They are two different debts. The second debt is entirely new. But let’s not quibble – the AMP is better at developing strategies than it is at naming them.
JUST LEAVE IT
This might sound like a radical, reckless idea, but one strategy is to simply leave your home loan un-repaid. It is not the best strategy, especially as you continue to have to pay non-deductible interest. But it can make good sense in some cases.
This strategy requires you to use an interest only account. We describe these more fully below in the section on investment debt, because these loans are most often used to service deductible debt. But interest only loans can also be used to finance personal debt such as a home loan as well. You just need the lender to agree to make the loan interest only.
The idea here is usually that the value of the home will rise over time. As long as the debt does not rise, the home-owner becomes more wealthy. Consider the following real world example: in 1999 a couple borrowed $168,000 to pay for 80% of their new home, then valued at $210,000. Their equity in the home was therefore worth 20%. By 2016, the home had increased in market value to $800,000. If the couple had simply met the interest expense on the loan, then they would still owe $168,000. But their equity has risen to now be worth 79% of the value of the home. They could sell the home, pay out the debt and buy a cheaper one outright for $632,000. Or, they could continue to service the loan and remain in this house, perhaps forever. It would then be left to their estate to pay out the loan after they die.
By 2016, if interest rates were 5%, then the interest on the loan was $8,400. This was just 1.2% of the $800,000 that the new home was now worth. So, if the home continued to increase in value by at least 1.2%, then this couple would continue to become more wealthy even without paying out the debt.
Consider another elderly gentleman who owned a home worth $300,000 in 2006. He was eighty years old, and the home needed some modifications to enable him to keep living in it. The family sought government funding but he did not qualify because he owned his own home. Happily, the family saw a financial adviser who recommended that they borrow the $20,000 needed to modify the home (the elderly gentleman did not have any spare cash). Interest rates were a bit higher back then and the debt cost around $1,400 a year to service. This equates to a bit less than $28 a week, or $4 a day.
The modifications were made and the man continued to live in the home for another nine years before he passed away. By then, the home had increased in value to $750,000. The estate sold the home and paid out the debt. Over nine years, the property increased in value by $450,000. This equates to approximately $136 per day – much more than the extra $4 that the man had to pay to service the debt.
Many people choose to discontinue repaying principal during the peak cost years of their life – typically when they have teenage children. The idea is to take some of the financial pressure off by extending the period of time it takes to repay the home loan. This strategy often sits more comfortably with families that have reduced their initial loan and/or experienced some capital growth, such that they have created equity in their home.
Of course, leaving debt unrepaid does involve risk: property prices can fall, especially for high-supply properties such as apartments, or new homes which can fall in value as the home stops being new. The strategy only really works if the property always rises in value. Relying on capital growth to repay your debt is not for everyone. But in certain circumstances, it is worth considering.