With historically high household borrowing levels and major banks recently opting to increasing lending rates, it is important that your debt position is reviewed regularly so it be managed and structured effectively to minimise borrowing costs.
Debt or borrowed money can play an important role in helping you achieve your lifestyle goals and objectives. The way debt is managed may depend on whether it is considered ‘efficient’ or ‘inefficient’.
Efficient debt (tax deductible)
In most cases, debt used to purchase assets that produce income (for example, a portfolio of shares or an investment property) qualify for a tax deduction in relation to interest costs. This form of debt is considered to be ‘efficient’.
Inefficient debt (non tax deductible)
Loans taken out to purchase services or assets which do not generate income (for example, to purchase a principal residence, a car or fund a holiday) do not qualify for a tax deduction in relation to the interest costs. In these cases the debt is considered to be inefficient from a wealth creation perspective and is often draining on your long-term wealth accumulation capacity when not managed properly.
Wherever possible you should try to accelerate the repayment of your inefficient debt. Outlined below are common debt reduction strategies.
Reducing inefficient debt
By accelerating the reduction of your inefficient debt, you can:
- Reduce your total interest payments and reduce the duration of your inefficient debts
- Increase the equity you have in your home which can be potentially used as security to borrow for investment purposes later on, and
- Potentially provide you with more cash flow at the end of the loan term that can either be used to repay other debt or to make additional investments
There are various debt management strategies that can be used to reduce inefficient debt. We have listed some common strategies below.
Increasing your regular repayments
Increasing the size of regular loan repayments involves transferring surplus cash into your loan on a regular basis. This will result in a reduction in the interest charged and principal owing on the loan.
- Loss of access to your funds, unless the payments are made into an offset account or redraw facility.
- Many fixed rate loans limit additional repayments and may also charge a fee.
- By reducing the term of a fixed rate loan, you may incur early payout fees.
Increasing payment frequency on your loan
As interest on your loan is calculated daily on your outstanding loan balance, the longer the period between your payments, the higher the average daily loan balance and the greater the interest charged. More frequent loan repayments will result in less interest being charged and may result in a reduced loan term.
Making additional lump sum payments
Making an additional lump sum repayment involves a one-off cash payment into your loan.
The benefit of this strategy is you will effectively be earning an after-tax return equivalent to your loan interest rate. It is unlikely you could obtain an after-tax return as high as this from other investments with the same level of risk.
- Loss of access to your funds, unless the payment is made into an offset account or redraw facility.
Utilising a credit card effectively in conjunction with your loan
You can retain access to additional loan repayments through the use of an offset account. Therefore, an effective debt management strategy is to take advantage of your mortgage offset account and the interest free period on your credit card.
Instead of using your cash to pay your everyday expenses (and as a result taking those funds away from your offset account), using your credit card leaves your cash in your offset account longer, reducing the effective balance of your loan and the daily interest that accumulates.
It is important to note this strategy will only be effective if you pay your credit card debt within the interest free period each and every month. This can be paid via a transfer from your offset account or from other cashflow.
- It is important you pay the entire amount owing on your credit card each month within the interest free period.
Consolidating your debt
A simple strategy to lower your overall interest rate and more easily manage your debt is to consolidate all debts into one loan that provides a lower interest rate and features to help you repay your inefficient debt faster.
Loan consolidation will save you interest where your new repayment and loan term are at least equal to your total current loan repayments and loan terms. Otherwise, you could be converting your short-term debts into longer-term debt and be paying more interest in the long run.
- Early termination fees may apply to your existing loan(s).
- The interest rate on your new loan may be higher than the rate on your existing loan(s).
- Loan consolidation can significantly increase your total interest costs if you make smaller repayments over a longer time.
- Application fees and stamp duty may be applied to your new loan.
In some cases, it may be appropriate to consider replacing inefficient debt with more efficient debt that can be used to create wealth tax effectively. This strategy is known as debt recycling but should only be undertaken after a thorough analysis of your financial situation.
Debt recycling can be an effective strategy to accumulate wealth over the long-term. It is a process of using surplus capital or cashflow to reduce inefficient debt and then replacing it with efficient debt in the form of an investment loan. The investment loan proceeds are then invested to form part of your investment portfolio. The inefficient debt is eventually extinguished and an investment loan with fully tax deductible interest remains.
There is no tax benefit available on debt used for personal purposes, but a tax deduction is available on the interest expense on investment loans where the loan is used to purchase income producing assets. Debt recycling therefore results in a more tax efficient outcome and wealth accumulation benefits through the accumulation of an investment portfolio. Note the investment loan would need to be repaid at some point in time.
To implement this strategy, your tolerance for risk should allow you to feel comfortable with borrowing to invest. There are two ways debt recycling can be undertaken:
Lump sum debt recycling
If you have available capital such as bank account savings, this can be used to repay any inefficient debt such as a home mortgage or personal loan. An investment loan can then be taken for the same amount and be used to invest in an investment portfolio.
Regular debt recycling
If you have regular surplus income, this can be used to increase the regular repayments on your inefficient debt such as your home mortgage or personal loan. An investment loan can then be increased by a corresponding amount and the proceeds used to invest in an investment portfolio.
With high household borrowing levels and major banks increasing their lending rates, it is important to review your debt position regularly. This will ensure you have the optimal structure in place and help minismise your borrowing costs.
If you are looking for assistance with strategies to own your home faster, using debt to help build wealth or general advice on our mortgage solutions please contact Calibre Private Wealth Advisers on 03 9824 2777 or email firstname.lastname@example.org