13 Aug Use Debt to your Advantage
Borrowing money to purchase assets is a powerful strategy to build long-term wealth. Typically, a home will be the first purchase made with the borrowed funds, but it should not be the last! Paying down home loans and other lifestyle debt, such as credit cards, not only saves you interest, it also releases capacity to borrow for investments such as shares and investment properties. These strategies can accelerate your wealth but do carry risk, and so should only be considered with professional advice.
The two types of debt are explained below.
This is used to buy goods, services and assets that don’t generate income, will depreciate in value, or have no value once they are used. You can’t claim the loan interest as a tax deduction. Using a credit card to pay for living expenses is inefficient if it’s not repaid within the interest-free period. This is because the interest on the debt isn’t tax-deductible and the things you buy generally have little or no resale value after use.
There are a number of instances where we need to use inefficient debt to fund the lifestyle we want. For example, car purchases are usually financed with borrowings. Where possible, we recommend clients salary package to obtain some tax benefits.
A mortgage to fund the purchase of a home you live in is also a form of inefficient debt, as the interest is not tax-deductible and the property does not produce an income. On the other hand, one needs to pay for shelter (the other option being paying rent, which is also not tax-deductible) and the home you live in is not subject to capital gains tax. Furthermore, once you have built equity in your home, this can be used to buy income-producing assets.
This is used to acquire assets that have the potential to grow in value and generate assessable income. You can generally claim the loan interest as a tax deduction and use the income generated by the asset to help repay the debt.
Using an investment loan to acquire an asset (like shares or property) is efficient because the asset has potential to appreciate in value, it generates income and the interest on the loan is generally tax-deductible.
[titled_box title=”Case Study ” bgColor=”#ff8400″ textColor=”#ffffff”] Joel and Ilana’s home loan stands at [pullquote3 quotes=”true” align=”right” variation=”orange” bgColor=”#ffffff” textColor=”#eda617″] The strategy of making additional mortgage repayments and using equity in their home to buy share based investments, mean that Joel and Ilana pay off their mortgage several years earlier and reduce their overall interest cost.[/pullquote3]$300,000 after upgrading their home. Their interest rate is 7 per cent per annum and Joel pays tax at a marginal rate of 38.5 per cent1. Joel owns a share portfolio worth $100,000 which he has accumulated over the years but hasn’t paid much attention to.
If they opt to maintain their current situation, their home loan remains at $300,000 and, because the interest payments are not tax-deductible, the after-tax interest cost will be approximately $21,000 per annum.
After assessing their goals and financial situation, Joel and Ilana’s financial planner explains that a better approach would be to:
- Sell down the $100,000 share portfolio to reduce the home loan;
- Borrow an equivalent amount through an interest-only investment loan secured by their home (in Joel’s name only); and,
- Use the borrowed money to invest in an actively managed share portfolio that is monitored on a regular basis.
If Joel and Ilana follow this advice, they’ll have a home loan of $200,000 and investment loan of $100,000. The after-tax interest cost of the home loan will be $14,000. However, because the investment loan interest ($7,000) may be tax deductible, the after-tax cost of this loan could potentially be $4,305 per annum.
In other words, their total debts remain at $300,000 but the after-tax interest bill could fall from $21,000 per annum to $18,305 and they benefit from active management of their share portfolio.
Their financial planner also suggests that:
- They use the income from the investments and the after-tax interest savings to pay off their home loan faster; and,
- When this home loan is repaid, they use the investment income to purchase more investments and build even more wealth in the future.
Joel and Ilana are able to cut seven years off their mortgage if they sell the portfolio in 10 years.2
Coupled with additional repayments of $200 per month, they reduce their mortgage duration by a further four years. In total, they shave eleven years off their mortgage, and an astonishing $120,000 in interest![/titled_box]
1. Includes Medicare Levy
2 .Based upon an investment income return of four per cent per annum and growth return of six per cent per annum.
About Reuben Zelwer
Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.