When we talk about smart lending structures we are really focusing on understanding the difference between ‘good debt’ and ‘bad debt’ and how you can structure your debt to pay less interest, reduce the amount of tax you pay and pay off your debt in less time. It is particularly important to reduce your bad debt as quickly as you can.
Debt is such a part of our lives with much of our income going towards servicing debt. If you can get the structure right it can make a huge difference to your overall financial health.
Let’s start by looking at the difference between ‘good debt’ and ‘bad debt’.
‘Good debt’ covers borrowing that is used exclusively for the purpose of acquiring assets that generate an income (and ideally offer additional returns by way of capital growth). When you borrow money for an investment property or a share portfolio, generally this is considered good debt because the interest you pay may be a claimable expense against your other income enabling you to reduce your tax payable. Therefore the cost of that debt is generally lower (depending on your tax rate) because you are getting a tax deduction – hence good debt is also often referred to as ‘deductible’ debt. This type of borrowing enables you to acquire growth assets faster, with the aim of improving your overall wealth position.
‘Bad debt’ is best described as lifestyle debt, such as credit cards, store cards and personal loans. It’s any debt that you can’t claim a deduction on – hence why it’s also referred to as ‘non-deductible’ debt. We also consider your home loan as bad debt – even though it’s used to acquire a property asset, which should grow in value over the long term (unlike cars, boats or other lifestyle assets), you can’t claim a tax deduction on the interest. Therefore it’s a more expensive debt in real terms, and one that you’ll want to get rid of as quickly as possible.
Smart ways to structure your lending
So now knowing the difference between ‘good debt’ and ‘bad debt’ it is important to structure your debts in order to improve your financial health. Here we look at a number of strategies that can help you achieve this.
1/ Pay off your bad debt first
Aim to pay off your non-deductible debts such as credit cards, personal loans and home loans first. Start with the ones that are attracting the highest interest rates. There is no point focusing on paying off your home loan with an interest rate of 4.1% when you have outstanding credit card debt that you are paying 19% interest on.
2/ Home loan and investment loan repayments
Where possible, set up your home loan with principal and interest repayments and your investment loan with interest only repayments. Use any surplus cash to pay into your home loan first. The reason for this is that you want more of your money paying down your non-deductible home loan than your deductible investment loan.
3/ Fixed and variable loans
You may also want to look at splitting your home loan into fixed and variable components. Fixing a portion of your loan gives you greater certainty and ease of budgeting for your repayments. And, the variable component allows you to pay extra repayments to reduce the loan size.
Having the variable component is important due to the limitations of fixed rate loans, such as a limited ability to make additional repayments, usually around $10,000 per annum and generally not being able to link a 100% offset account to your loan.
4/ Change the way you save
Traditionally people use savings accounts as a home for their money especially when saving for goals. However, there is a better way: use an offset account linked to your home loan for savings rather than an interest-bearing savings account.
The reason for this is rather than earning interest at say, 2.5% (the after-tax rate is even lower given that you’ll pay tax on the interest income), you’re better to save interest at 4.1% on your home loan.
Some lenders allow you to link up to ten offset accounts to your variable home loan under the one package, so you can set aside funds for different savings goals. For example a holiday, a new car or renovations. The total sum of your offset account balances reduces the home loan balance on which interest is calculated – effectively helping you to pay off your home loan sooner while saving for your goals!
5/ Consider fixing your investment loan
You may want to consider fixing your investment loan rate. We are seeing some attractive offers on fixed investment rates – there are lenders currently offering 3.99% fixed for 3 years for investment loans. This may be a smart decision if you have a home loan that you will be paying off first, so you’re not going to make any additional repayments on your investment loan. A fixed rate will allow you to more easily budget for the investment loan repayments in your cash flow calculations.
6/ Have your loans reviewed annually
It is important to have your loans reviewed annually. The lending market is highly competitive and you’ll often get a better rate if you are willing to refinance. The cost of moving lenders is often less than you think and some lenders offer refinance rebates that may result in you being in front as a result of switching.
It’s important to bear in mind when comparing rates that investment property loans are usually around 0.25% higher than owner occupied home loans. Many lenders will give their best rate for owner-occupied loans paying principal and interest repayments. Some lenders won’t even allow interest only loans for owner occupied purposes, whilst others will charge a higher rate.
It’s important that your loan structure aims to take advantage of not only the best possible rate, but also offers features that maximise your ability to pay off your non-deductible debt as soon as possible.
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