Implementing various debt management strategies such as optimizing cash flow, prioritizing repayment, and exploring consolidation options can accelerate the accumulation of wealth.
Guidance for Managing Debt
Although having a credit license or being a credit representative is required for recommending lending products, advisors who lack this license can still guide the cash flow consequences of debt, help clients optimize the tax efficiency of their debt, and expedite the repayment of debt that is not linked to wealth creation.
There exist several tactics to aid clients in diminishing ‘bad’ debt and utilizing ‘good’ debt to generate wealth. ‘Bad’ debt refers to debt used to buy things that do not produce income, depreciate, or become valueless after use. It is considered ‘bad’ debt due to two reasons:
Interest expenses incurred on it cannot be claimed as a tax deduction.
The debt does not generate any revenue, and the borrower must rely on their funds to pay off the loan.
Some examples of this include:
Credit and store cards – utilizing credit and store cards to cover living expenses can be costly if the outstanding balance isn’t paid off within the interest-free period (usually monthly). Interest rates are often much higher than other types of loans, making even “cheap” purchases expensive.
Personal loans – using a personal loan to purchase a car or boat is not efficient. These assets do not generate income, and the incurred interest is generally not tax-deductible. Additionally, the interest rate is typically higher than that of loans secured by real estate.
Home loans – although residential property usually appreciates in value over the long term, if the borrower resides in the property, they are not earning income from it and are unable to claim loan interest as a tax deduction.
In contrast, ‘good’ debt is utilized to purchase assets that produce income and have the potential to appreciate in value, such as investment properties, managed funds, or shares. Investment loans are deemed ‘good’ debt for the following reasons:
The earnings generated by the investment can be utilized to repay the loan.
The interest costs may be partially or entirely tax-deductible.
It can facilitate the acceleration of wealth creation.
Managing Cash Flow Effectively
Clients can decrease the interest paid on their home loans by optimizing the usage of their surplus cash flow. Interest on these loans is typically computed based on the daily loan balance and added to the loan balance monthly. The average daily loan balance (and hence the interest charged) can be decreased by employing one or more of the following methods:
Boosting Repayment Frequency for Faster Debt Reduction
Making fortnightly repayments can reduce the loan balance every two weeks instead of monthly, resulting in lower interest charges over the loan’s term for your clients.
Accelerating Debt Repayment by Increasing Payment Amounts
Clients can utilize their surplus cash flow by increasing their repayment amounts to expedite the repayment of the loan.
Using Salary to Reduce Debt: Paying Wages Into Loans
Directing one’s salary into a loan account that comes with a redraw facility or a 100 percent offset account provides the following advantages to clients:
Effectively increases the repayment frequency.
Reduces the loan size on a more frequent basis.
Offers a higher after-tax return than what is typically obtained from a savings account.
Provides easy access to funds when required.
Potential Pitfalls of Using a Credit Card for Living Expenses
Opting for a credit card to cover living expenses can keep money in the client’s offset (or redraw) account for an extended period, resulting in a reduced loan amount utilized for interest calculation. However, to avoid incurring interest charges on the credit card, the credit card balance must be paid within the interest-free period every month.
Factors to Consider When Providing Advice on this Strategy
Consider the following aspects while advising on this strategy:
Are your clients utilizing their income and tax deductions to the fullest while minimizing expenses?
When using a home loan simulator, it is customary to halve the monthly repayment amount to illustrate the advantages of fortnightly repayments. Clients must have the additional cash flow to use this method since they will be making two extra repayments per year by paying fortnightly instead of monthly.
Can the client’s employer deposit salary directly into an offset account or home loan?
Does the home loan provider allow for additional repayments? In the case of a fixed-rate loan, the provider may not allow them (or there may be an annual cap).
Does the home loan provider permit automatic monthly repayment of credit card balances? This could help ensure that timely repayments are made to avoid unnecessary interest charges on the credit card.
Leveraging Redraw Facilities for Investment Loans
This approach is not recommended for investment loans.
According to TR 2000/2 issued by the ATO, a deposit into an investment loan with a redraw facility is viewed as a partial repayment of the investment loan. If some of the available funds are subsequently withdrawn and used for personal purposes, the interest linked to this extra amount (i.e., new loan) is not tax-deductible.
It becomes challenging to determine the amount of deductible interest when subsequent deposits and withdrawals are made into or from a redraw facility. This is due to each deposit being treated as a proportionate part repayment of the investment and non-investment components of the loan.
Tax Deductions for Investment Loans
The deductibility and non-deductibility of the debt must not be perceived as linked. This outcome resulted from the High Court’s verdict in Commissioner of Taxation v Hart [2004] HCA 26, which favored the ATO by holding that the scheme involved was within the ambit of Part IVA.
As a general rule, would “de-coupling” the loans not be subject to Part IVA? De-coupling the loans could make it more difficult for the ATO to claim that Part IVA should apply, although it is worth noting that the High Court did not consider some other relevant factors when reaching its decision.
It is theoretically possible for the ATO to challenge a claim for the full deduction of an investment loan on which all interest has been capitalized. As a result, clients contemplating this strategy should seek professional guidance and, if possible, a private binding ruling on the arrangement.
Optimizing Cash Reserves for Maximum Benefit
This approach is ideal for clients who possess a home mortgage and have some extra cash in a savings account. By utilizing this strategy, clients can benefit from a higher after-tax return and eliminate bad debts while maintaining access to their funds.
Money in a regular bank account earns interest at a typically lower rate than the interest charged on a home loan. Additionally, the client will be taxed at their marginal rate (up to 47 percent, including the Medicare levy) on each dollar of interest earned. With this strategy, the client can allocate this money to:
The home loan and access it through a redraw facility, or
A 100 percent mortgage offset account.
Both options decrease the balance of the home loan by the amount invested, resulting in a reduction of the interest charged on the loan.
Consolidating Debts for Better Management
Debt consolidation entails replacing expensive personal and credit card debts with a more affordable home mortgage facility. This approach is ideal for clients who have home equity but are also repaying a mortgage while managing other debts such as personal loans or credit cards. Clients can increase their mortgage facility and use the additional funds borrowed to pay off their other debts at a lower interest rate.
It is crucial for the client to maintain the same repayment levels as before consolidating their debts. Failing to do so may result in a longer loan repayment period and higher overall interest charges.
This strategy is also useful for:
optimizing cash reserves
managing cash flow.
If the client’s present home loan does not offer a mortgage offset and/or redraw facility, you may consider (subject to credit licensing requirements) recommending they refinance to a product that provides these features.
Factors to Consider When Providing Advice on Debt Consolidation Strategy
The cost of refinancing, including application fees, stamp duty, and early repayment fees, may be charged to the client. It may not be worthwhile if the cost exceeds the potential savings.
Does the client possess enough surplus cash to effectively reduce their debts? If so, debt consolidation may not be necessary.
Does the client require cash access for unforeseen emergencies? Surplus cash can be deposited into an offset account or loan and accessed via a redraw facility.
The client should contemplate income protection insurance to ensure they can continue to make their loan repayments if they fall sick or are unable to work due to incapacity. This insurance can provide peace of mind to the client that their dependents will not experience financial stress.
Maximizing the Benefits of a Lump Sum
For clients who receive a significant lump sum, such as a work bonus or inheritance, and have a home loan or other debts, these measures can aid in reducing bad debt and substituting it with good debt:
Use the lump sum to decrease the home loan balance, either by directly paying it into the loan or a 100% offset account.
Take out an investment loan for an equal sum and invest it in shares/managed funds.
While the client’s overall debt level remains constant, the interest on the investment loan should be tax-deductible. This lowers the client’s after-tax interest costs while also constructing an investment portfolio to help generate long-term wealth. The client can also use their tax savings to reduce their home loan balance faster.
As with all strategies, gearing should only be used after thoroughly explaining the risks to your clients and ensuring they understand them.
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Debt recycling involves borrowing against the home’s equity for investment purposes and utilizing the net income from investments, along with any surplus cash, to replace bad debt with good debt. This strategy “recycles” debt and helps accelerate wealth creation.
This approach is suitable for clients who have a home loan and want to increase their wealth using home equity and gearing. The client uses some of the available equity to take out an investment loan and repeats these steps at the end of each year until the home loan is paid off:
The client invests borrowed funds into growth assets such as shares or managed investments.
The client then uses the investment income and tax savings, as well as surplus cash flow, to reduce their outstanding home loan balance.
At the end of each year, the client borrows an amount equivalent to the amount they paid off their home loan.
The client then uses this money to buy additional investments.
As with all strategies, gearing should only be used after thoroughly explaining the risks to your clients and ensuring they understand them.
It may take slightly longer to pay off the home loan, as some of the surplus cash is used to meet interest costs on the investment loan, which increase over time. However, the client starts constructing their investment portfolio earlier. If the client’s after-tax return from investments is higher than the loan’s interest costs, it is more effective to reinvest surplus cash flow rather than using it to pay off the investment loan, as the interest is tax-deductible.
Considerations for Advising on Debt Recycling Strategy
If the investment loan is interest-only, the client can direct more funds to pay off the home loan more quickly. However, this also means that the investment loan balance will not be reduced unless the client makes additional repayments.
The client could reduce application costs by obtaining a higher pre-approved limit for the investment loan. This means they won’t need to re-apply at a later date if they want to borrow additional funds.
The suitability of a line of credit (a home loan with investment sub-accounts) should be evaluated carefully. While this option provides greater flexibility and convenience, the interest costs of this arrangement may be higher than that of a standard home loan.
Maximizing Tax Efficiency for Investment Loans
Using an offset facility can help maintain tax deductions and provide clients with access to spare money for non-investment purposes. This strategy is ideal for clients with an investment loan who are saving for a future non-investment purpose, like a holiday or their children’s education.
If the client uses their spare cash to pay off their investment loan, they could earn a higher after-tax return than if they kept the money in a separate cash account. However, if they pay off part of the loan, the size of the loan is reduced. If the client needs to redraw cash for non-investment purposes, they cannot claim a tax deduction on the interest charged on the redrawn money.
Depositing spare cash into a 100% offset account linked to the investment loan may be more tax-effective for clients than paying off part of the loan. An offset account is separate from the loan, and the client can make repayments without affecting the size of the investment loan or the tax deductibility of the interest.
Making Interest Prepayments
This strategy is most beneficial for clients with deductible debt who expect to have higher taxable income in the current financial year than in the following year. By prepaying the interest expense for the next year, they may be able to claim a tax deduction for that interest in the current tax year.
Generally, interest expense on loans used to acquire assets that generate assessable income is tax-deductible in the year it arises. However, borrowers can prepay the interest expense on geared investment portfolios for up to 12 months and receive an entitlement to the deduction in the current financial year.
Prepaying interest enables an individual to bring forward the tax deduction they may be entitled to in the following year to the current year, creating tax-planning opportunities. Moreover, many providers offer prepayment at a discounted rate, allowing clients to save further.