DEBT MANAGEMENT

The bank is not your friend

Look for the cheapest loan

Ensure interest is tax deductible

Get an appropriate interest rate

The home as security for a loan

Pay the interest

Study the contract

Make sure the application is clear

Chapter 6 - Some general thoughts about borrowing

Ensure you have cash flow

Do not borrow too much

Keep communication open

Offer subject to finance

Hints for income tax time

Keep your banks separate

Let someone do the work

Finally, we thought we should let you know some other general thoughts about borrowing. These thoughts come from our specialist training and experience in financial planning and we hope that they will be of use to you as well.

Your bank manager is not your friend

 

Your bank manager is your opponent. The game of getting a loan might be played in a good spirit – but he or she is on the other team. The bank’s – and therefore the bank manager’s – income is your cost. He or she sits on the other side of the table and wants you to pay as much as possible for the money you borrow. You can be friendly but do not be friends.

Look for the cheapest loan possible

 

The interest reduces the net return on the investment (by which we also mean your investment in your family home). The higher the interest rate, the lower the net return. So it makes sense to minimise the interest paid on a loan. Our observation is that clients are usually far too polite about accepting interest rates that are higher than they need to. Remember, the Bank Manager is not your friend.

Ensure interest is tax deductible

 

Try always to ensure that the interest is tax deductible. For this to be the case, the borrowing must be connected to assessable income.

When debt is used to buy or hold an investment the interest is deductible.

 

If you have private, non-deductible debt as well as investment debt you should separate your loans so they are not used for a mix of private and investment purposes. Quarantine your investment loans. Don’t mix them up. This makes it clear which loan was used for investment purposes, and helps ensure the interest is tax deductible.

Get an appropriate interest rate

 

Make sure that your interest rate is not too high. Some banks try to charge higher rates than necessary. The person at the bank is usually on commission (often that includes the bank manager), so the incentive to help the borrower (ie you) get the lowest rate possible may not always be high.

Sometimes a client will take a loan in the name of the trustee of his or her family trust, or some other trust. This trustee is usually a company, with the letters ‘Pty Ltd’ after the name. Some lenders will assume that the loan is a business loan and try to apply a higher interest rate. Don’t agree to this. Banks will lend at home loan rates to a company or trust if the underlying security is a residential property.

In summary, if the security is residential property the home loan interest rate should apply. This can require the adviser to advocate for the client.

The home as security for a loan

 

Any asset can be used to secure a loan. It does not have to be the asset bought with the loan. For example, an investor may mortgage their home to buy shares. The interest will be deductible because the purpose of the loan is to earn assessable income, in the form of dividends.

The interest rate will be lower because the home is the best security for a loan.

This is the cheapest way to finance an investment. Sometimes clients worry about using the home as security for a loan. They are concerned the home may be lost if the investment goes bad. This should not really be an issue. The issue is the net wealth of the borrower. Net wealth is the difference between what the borrower owns and what the borrower owes. If a borrower owes $100,000 on a $500,000 property, for example, and there are no other assets, then the net wealth is $400,000.

Provided the overall net wealth exceeds the value of the home, the home will not need to be sold. The other assets can be sold to pay off the liabilities. Consider an example:

 

Susan owns a home worth $500,000 and has $100,000 cash saved. This means that she has $600,000 in net wealth. She borrows $240,000 against her home and uses it to buy index-based managed funds (using dollar cost averaging, of course). Susan now has $840,000 in assets and $240,000 in debt – her net wealth is still $600,000. If something happens and she needs to repay the loan she can sell the index funds. She will not have to sell the home. If the value of the index funds falls by a large amount – even 50% – then her net assets will fall to $480,000.

The key, then, is to always allow a buffer or margin of safety when borrowing to buy assets.

 

Consider also the case where an investor borrows against the value of an investment asset that falls in value. The lender forces the asset to be sold – and then takes further action against the investor if selling the asset does not repay the entire loan. If that means that the investor ends up having to sell or mortgage their home to repay the debt, then that is what the lender will pursue. The fact that the home was not used as security for the loan will not prevent the lender from taking action against the borrower, who may end up having to use their home to repay the debt anyway.

There are some structures that can be used to ‘protect’ assets such as the home. If you think you need something like this, then let us know and we can provide specific advice. But be aware that lenders also know how these structures work and will simply not make a loan if they think there is a chance that the loan will not be repaid.

In summary, the advantage of lower interest rates, which means higher net returns and less risk, often justifies using the home as security for a loan. Just keep the debt to prudent levels and use it to buy well-regarded assets.

Pay the interest

 

The ATO does not like allowing deductions for un-paid interest. There is some doubt as to whether this is correct at law, but one thing is certain: it’s simply easier to pay the interest on time than it is to argue with the ATO. So, make sure all interest is paid, and not capitalised, if you are claiming a deduction.

Study the contract

 

Get advice. Research the costs before you sign the contract. Make sure you know the interest rate, the principal repayment rate, the administration costs and the penalties for early repayment. Shop around. The first offer is unlikely to be the best offer.

Make sure your application is clear and to the point

 

Support it with accounts, company searches, business plans and similar documents where necessary. These materials are best included as appendices to the main application as they may cloud the message you are trying to deliver. If the loan is for business or investment purposes, stress this, as it may be relevant if the ATO questions the deductibility of any interest claimed on the loans down the track.

Ensure you have the cash flow for repayments

 

Ensure your finance application shows that all repayments can be met out of your existing and expected cash flows. If asset sales are contemplated in the short or medium term say so, as this is relevant to your capacity to service the debt. Financiers may not be impressed if the repayment of principal depends solely on the sale of the object investment.

Do not borrow too much

 

Most banks work on a debt-to-equity ratio of about 70:30. In working out the value of your equity they discount historical cost by factors representing their expected resale experiences. Take account of these discount factors before you commit yourself to a transaction. Ensure your finance application includes all relevant materials, including financial information that does not necessarily favour your application. If something goes wrong later and the lender finds out that information was withheld, problems will arise.

And if you have to fib to get a loan, you should not be getting the loan.

Keep the communication channels open

 

If something does go wrong, tell the lender immediately. This is important because lenders often base their recovery actions on their perceptions of how the borrower behaved. If your word is your bond, then you will get much better treatment if an unexpected situation arises. Because trust has been established, the lenders are more likely to help out if needed. Open and honest communication is the key to building this sort of a relationship, and once it is created, you shouldn’t waste it.

Lenders will be reasonable if you are reasonable, so play with a straight bat at all times.

Offer subject to finance

 

If you are borrowing to buy property, consider making your offer subject to finance from a specified branch of a specified bank at a specified time, say a month. If something goes wrong you will probably not lose your deposit. If you change your mind within the specified timeframe you may be able to “arrange” for your finance application to be refused so you can get your deposit back.

But make sure that the finance condition specifies which bank and even which branch of that bank. If you do not do this the vendor may arrange finance for you through a lender you would not have chosen to use.

Hints for income tax time

 

Consider a facility such as a fully drawn advance, or an overdraft, that allows you to pre-pay interest. Pre-paid interest is generally tax-deductible in the year it is pre-paid, provided the pre- payment period does not extend for more than 13 months.

Non-deductible debt, which is not connected to a business or investment activity, is the most expensive debt. Every $1 of interest accounts for up to $2 of pre-tax income. A basic tax planning strategy is to pay off expensive non-deductible debt as soon as possible and defer paying off cheap deductible debt for as long as possible. If you have a 15 year home loan of $200,000 and a 15 year investment loan of $200,000 it makes sense to pay off the home loan at twice the usual rate and pay nothing on the investment loan.

Keep your banks separate

 

Separate your financiers. For example, consider having your home loan with the ANZ, your business loan with the National Australia Bank and your credit card with Westpac, and do not let them have cross-securities. Each bank should have security over just one asset.


This may sound messy, but if something goes wrong it will be a lot harder, if not impossible, for each bank to tie up the various securities provided to them.

Let someone do the work for you

 

Use a consultant who is experienced in dealing with banks and who can represent your interests competently. The consultant should have a good handle on both the accounting and legal aspects.

Consider using a finance broker. They are constantly in touch with the market. This saves you time dealing with lenders and saves you money because in most cases the broker can get you a better interest rate. Normally using a broker does not cost you anything because the lender pays the broker, not you. Because dealing with a broker is typically easier for the lender than dealing with you directly, the lender saves money and this is the money used to pay the broker; you do not pay higher costs because a broker is involved.

We can assist you here, and we guarantee that you will not pay more for your loan if you obtain finance help through us.

5. Special purpose debt:
Reveerse mortgages
Home Page

 ©2016 WHOLE WEALTH

  • White LinkedIn Icon
  • White YouTube Icon
  • White Instagram Icon
  • Twitter Clean
  • White Google+ Icon