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Should I Pay Off My Home Loan or Start Investing?

15 Aug 2013 8:05 PM - Joshua Stega, Financial Adviser Sydney

The difference between deductible and non-deductible debt

A common question asked by clients is whether they are better off using surplus funds to pay off their home mortgage or to make an investment.

Before we answer this question we need to understand the difference between deductible and non-deductible debt.

What is deductible and non-deductible debt?

Deductible debt arises where the interest on the loan is tax deductible. An example would be an investment loan. The reason an investment loan is tax deductible, is because the money has been used to invest in an asset that will generate assessable income.

Non-deductible arises where the interest on the loan is not tax deductible. The most common example is a loan used to buy a home to live in. These borrowed funds have been used to purchase an asset which will not produce an assessable income. 

Why pay off non-deductible debt first?

As the interest on this debt is not tax deductible it has a significantly higher after tax cost than deductible debt.

How does this work?

Most people assume the cost of debt is the actual interest rate, for example 7%.

This is incorrect, because you have to consider whether you are paying the loan using before or after tax dollars.

1.    If the loan is non-deductible you are using after tax dollars.

2.    If the loan is tax deductible you are using before tax dollars.

Example – After Tax Costs

If you are currently on the highest margin tax rate, every dollar you earn over $180,001 is taxed at 46.5%. This means that if you earn an additional $1,000, $465 of this goes directly to the Australian Tax Office (ATO).

If you have a non-deductible debt such as a mortgage, the $465 in your bank account goes to paying the interest on that loan. This means on a loan at 7%, the real cost to you was 13.1%. Even if you average rate of tax (total tax paid on your income) was say 25%, the after tax cost of non-deductible debt is still 9.33%.

If the loan was for an investment property, the interest would be tax deductible, which in effect means you are paying the costs using before tax dollars. This means that the cost of 7% loan to you is 7%, after tax. The headline rate is the same as what you are paying. In most cases you won’t receive this difference back until you do your tax return at the end of the year, but it does come back.

So should you pay off your mortgage or start an investment portfolio?

The simple answer is that you will be better off purchasing an investment if the after tax return of the investment is higher than the savings generated from repaying the housing loan.

If you are on the highest marginal tax rate and the mortgage rate is 7%, this will mean that you will have to find an investment that can generate 13.1% p.a. after tax and other costs, to be better off investing rather than paying down your loan.

While in theory this level of return is possible to achieve, we tend to prefer the easier option: pay off your non-deductible debt then start investing.

Kerry Packer on Tax:

“I am not evading tax in any way, shape or form. Now of course I am minimizing my tax and if anybody in this country doesn't minimize their tax they want their heads read because as a government I can tell you you're not spending it that well that we should be donating extra.”

 

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The Wealth Guy | Joshua Stega Financial Adviser Sydney

Joshua Stega, is head of financial advice at JAS Wealth (privately owned financial planning firm in Sydney). He helps successful individuals manage their wealth. He has a Masters in Taxation & Financial Planning, is a Fellow of the Taxation Institute, a SMSF Specialist Advisor and has significant direct investment experience.    Google+     Twitter     LinkedIn     Facebook     Instagram

M.TaxFP, LLB(Hons), B.Bus(Acc), FTI, Adv.DipFP, DipFP, SMSF Specialist