Debt management strategies

Technical resource

There are a number of debt management strategies that can be implemented to accelerate wealth accumulation involving cash flow, repayment and consolidation.

Advising on debt

While you’ll need to have a credit licence or be a credit representative to be able to recommend lending products, advisers who are not credit licenced are still able to advise on the cash flow implications of debt, assist clients with maximising the tax effectiveness of their debt, and accelerate the repayment of debt not associated with wealth creation.

There are a number of strategies to help clients reduce ‘bad’ debt and use ‘good’ debt to create wealth. ‘Bad’ debt is debt used to purchase anything that doesn’t generate income, something that loses its value, or has no value once it’s been used. It’s considered to be bad because:

  • a tax deduction cannot be claimed on the interest expense incurred, and

  • the debt doesn’t generate any income and the borrower has to use their own cash resources to repay the loan.

Examples include:

  • Credit and store cards - using these to pay living expenses can be inefficient if the outstanding balance isn’t paid in full within the interest free period (usually monthly). Interest charges are generally significantly higher than for other loans, making any ‘cheap’ purchases potentially expensive.

  • Personal loans - using a personal loan to buy a car or boat isn’t efficient. These assets don’t produce any income and the interest incurred usually isn’t tax deductible. The interest rate is also typically higher than that for loans secured against real property.

  • Home loans - although residential property generally increases in value over the long term, if the borrower lives in the home, they aren’t receiving income from it and they can’t claim the interest on the loan as a tax deduction.

‘Good’ debt on the other hand, is used to buy assets that generate income and also has the potential to increase in value, such as an investment property, managed funds or shares. Investment loans are considered ‘good’ debt because:

  • the income the investment generates can be used to help repay the loan

  • the interest costs may be partly or fully tax deductible, and

  • it can assist with accelerating wealth creation.

Control cash flow

Better utilisation of surplus cash flow can help clients reduce the interest payable on their home loan. Interest on these loans is normally calculated on the daily loan balance and then added to the loan balance on a monthly basis. Clients can reduce their average daily loan balance (and consequently the interest charged) using one or a combination of the following options.

Increase the repayment frequency

A fortnightly repayment has the impact of reducing the loan balance every two weeks instead of monthly, so over the term of the loan, your client can incur less interest.

Increase the repayment amount

Clients can use their surplus cash flow, increasing their repayment levels to help pay off the loan amount sooner.

Pay salary into loan

By having salary paid into the loan account with a redraw facility or a 100 per cent offset account, the client benefits from:

  • effectively increasing the repayment frequency

  • reducing the size of the loan on a more regular basis

  • a higher after-tax return than they would usually obtain from a savings account, and

  • easy access to their funds when they need them.

Using a credit card for living expenses

By using a credit card to cover all living expenses, money is kept in the client’s offset (or redraw) account for a longer period of time, reducing the loan amount used for the interest calculation. The credit card balance must be paid each month within the interest-free period to avoid incurring interest charges on the credit card.

Things to consider when advising on this strategy

  • Are your clients making full use of their income and tax deductions and limiting expenses?

  • A monthly repayment amount is usually halved to demonstrate the benefits of fortnightly repayments using a home loan simulator. The client will actually make an extra two repayments per year when paying fortnightly as opposed to monthly (e.g. $1,000 a fortnight is the same as $26,000 per year, whereas $2,000 a month is the same as $24,000 a year), therefore this method requires some additional cash flow.

  • Can the client’s employer pay salary directly into an offset account or home loan?

  • Does the home loan provider allow additional repayments? It may not if the loan is at a fixed rate (or there may be an annual limit).

  • Does the home loan provider allow for automatic repayment of credit card balances monthly? This could help ensure timely repayments are made to avoid any unnecessary credit card interest charges.

Using redraw facilities for investment loans

This strategy is not recommended to be used for investment loans.

In TR 2000/2 the ATO indicated that a deposit into an investment loan containing a redraw facility is seen as a repayment of part of the investment loan. A subsequent withdrawal of some of the available funds is treated as a new loan. If this loan is used for private purposes, then the interest relating to this additional amount i.e. new loan, is not tax deductible.

If subsequent deposits and withdrawals are made into or from a redraw facility then it becomes difficult to calculate the deductible interest. This is because every deposit will be treated as being a proportionate part repayment of the investment and non-investment component of the loan.

Tax deductions with respect to investment loans

The deductible and non-deductible component of the debt must not be seen to be linked. This was a consequence of the High Court's decision in Commissioner of Taxation v Hart [2004] HCA 26, which was decided in favour of the ATO on the basis that the scheme involved was caught by Part IVA.

Does this mean that, as a general proposition, ‘de-coupling’ the loans would not involve Part IVA? The de-coupling of the loans would seem to make it harder for the ATO to argue that Part IVA should apply, however, it is important to note that some other relevant issues were not considered by the High Court when making its decision.

It is in principle possible for the ATO to contest a claim for the full deduction in respect of an investment loan on which all the interest has been capitalised. In these circumstances any client contemplating this strategy should seek professional advice and preferably a private binding ruling in relation to the strategy.

Effective use of cash reserves

This strategy is suitable for clients who have a home mortgage and some additional cash within a savings account. Once implemented, they can earn a higher after-tax return and pay off bad debts but still have access to their money.

‘Spare’ cash in a normal bank account earns interest usually at a lower rate than what is charges within a home loan. Also, the client will pay tax at their marginal rate (up to 47 per cent, inclusive of the Medicare levy) on every dollar they earn in interest. Using this strategy, the client can direct this cash into:

  • the home loan and access it via a redraw facility, or

  • a 100 per cent mortgage offset account.

Both options reduce the balance of the home loan by the amount invested, so the interest charged on the loan is reduced.

The client won’t earn interest on the amount invested in the home loan or the mortgage offset account so they also won’t have to pay any tax on earnings.

Account

How do interest rates compare?

Is the interest taxable?

Does it help pay off the home loan quicker?

Is the money easy to access?

Normal bank account

Low

Yes, at marginal tax rate

No

Yes

Offset account

Higher*

No

Yes

Yes

*Full or 100% mortgage offset loan. Some lenders build in a cost for this feature by charging a higher interest rate on the loan.

Things to consider when advising on this strategy

  • An offset facility may be more effective than a redraw facility after taking into account fees and restrictions on any redraw.

  • Check if the client’s current home loan has a 100 per cent offset facility. If not, can it be added?

  • Is the client’s home loan a fixed-interest loan or does it have a fixed-interest component? Offset accounts generally only apply to the variable rate portion of the loan, and possibly a capped amount on the fixed rate portion of the loan.

Debt consolidation

Debt consolidation involves the refinancing of expensive personal and credit card debt with a more cost effective home mortgage facility. This strategy is suitable for clients who have equity in their home but are paying off a mortgage and also have other debts such as personal loans or credit cards. They can increase their mortgage facility and use the extra money borrowed to pay off their other debts at an interest rate which is likely to be lower.

It’s important that the client maintains the same repayment levels prior to consolidating their debts. If they don’t, they could end up taking longer to repay the loan and incur more interest overall.

This strategy can also be used for:

  • Effective use of cash reserves

  • Controlling cash flow

If the client’s current home loan does not provide a mortgage offset and/or redraw facility, you may consider (subject to credit licencing requirements) whether it’s appropriate to recommend they refinance to a product that has these features.

Things to consider when advising on this strategy

  • The cost to the client of refinancing, e.g. application fees, stamp duty and early repayment fees may apply. It may not be viable if these costs are likely to exceed the amount they potentially save.

  • Does the client have enough surplus cash to sufficiently reduce the debts? If yes, they may not need to consolidate.

  • Does the client require access to cash for emergencies? Surplus cash could be paid into an offset account or paid into the loan and accessed via a redraw facility.

  • The client may consider income protection insurance so that they can still meet their loan repayments if they become sick or are incapacitated and unable to work. This insurance can help give the client peace of mind that their dependants won’t be put under financial stress.

Effective use of a lump sum

For clients who have received a substantial lump sum (such as a bonus from work, or an inheritance) and have a home loan and/or other debts, these steps can assist with reducing bad debt and replacing it with good debt:

  • Use the lump sum to reduce the home loan balance (either paying the lump sum directly into the loan or a 100% offset account)

  • Take out an investment loan for an equivalent amount, and invest this into shares/managed funds.

Although the client’s overall debt level is unchanged, the interest on the investment loan should be tax deductible. This reduces the clients after-tax interest costs and builds an investment portfolio to help create long-term wealth. The client could also reduce their home loan balance faster using their tax savings.

As with all strategies, gearing should only be used where the risks have been fully explained to your clients and they understand the risks.

Example

Damian received an after tax amount of $150,000 from an employment termination payment. He started working for a new employer after two weeks, and wishes to use this $150,000 to purchase investments. He also has a $300,000 home loan and pays 3.25 per cent interest per annum and his marginal tax rate is 39 per cent (including Medicare Levy). Damian can either use the $150,000 to buy investments directly, or pay off his home loan balance and use the equity to borrow $150,000 to buy the investments. The outcome of each option is shown below.

Option 1: Damian uses the $150,000 to purchase investments

Loan type

Amount

Interest at 3.25% pa (simple interest)

Less tax saving

After-tax interest

Total after-tax interest cost

Home loan

$300,000

$9,750

-

$9,750

$9,750


Option 2: Damian reduces his home loan balance and takes out an investment loan

Loan type

Amount

Interest at 3.25% pa (simple interest)

Less tax saving

After-tax interest

Total after-tax interest cost

Home loan

$150,000

$4,875

-

$4,875

$7,849

Investment loan

$150,000

$4,875

$1,901

$2,974


Using this strategy, Damian’s overall debt is the same. The interest he is effectively paying (after tax) is reduced from $9,750 to $7,849 – a saving of $1,901. In addition, Damian can use the investment income and associated tax savings to pay off his home loan sooner. After he has repaid the home loan, Damian can use the investment income and tax savings to purchase more investments, further building his wealth for the future. This is covered later in 'Debt recycling' below.

Things to consider when advising on this strategy

  • Your client may want to simply use the lump sum to reduce their home loan balance and not purchase any investments. It should be explained that although this strategy reduces non-deductible debt, it may not be as effective as using the money to purchase investments.

  • This strategy can be applied to existing investments the client may want to sell. The client could use the proceeds from the sale of investments to reduce their home loan balance and borrow an equivalent amount to invest in other income producing assets (i.e. replacing non-deductible debt with deductible debt).

  • The client should be cautious when using this strategy to sell and repurchase the same asset. The ATO may consider this a tax-avoidance strategy and apply penalties including denying any interest deductions.

  • Investment loans should be separated from the home loan to avoid problems determining which of the interest costs are tax-deductible.

  • To be eligible to claim interest as a tax deduction, investments purchased with borrowed money generally need to produce an income.

Debt recycling

Debt recycling is borrowing against the equity in the home for investment purposes and applying the net income from the investments (plus any cash surplus) to replace bad debt with good debt. This ‘recycles’ debt to assist in accelerating wealth creation.

This strategy is appropriate for clients who have a home loan and want to accelerate their wealth creation 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 money into growth assets such as shares or managed investments

  • The client then uses the investment income and tax savings plus surplus cash flow to reduce their outstanding home loan balance

  • At the end of each year, the client borrows an amount equal to what they’ve paid off their home loan

  • The client then uses this money to buy additional investments

As with all strategies, gearing should only be used where the risks have been fully explained and understood by your client.

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 increases over time. However, the client begins building their investment portfolio sooner. Provided the client’s after-tax return from their investments is greater than the interest costs of the loan, it’s likely to be more effective to reinvest surplus cash flow than use it to pay off the investment loan as the interest is tax deductible.

Things to consider when advising on this strategy

  • If the investment loan is interest-only, the client can direct more funds to pay off the home loan quicker.

  • 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) - be aware that the interest costs of this arrangement may be higher than that of a standard home loan.

Tax efficiency of investment loans

An offset facility can be used to effectively maintain tax deductions and provide clients with access to spare money for non-investment purposes. This strategy is suitable for clients with an investment loan who are currently saving for a future non-investment purpose such as a holiday or children’s education.

By directing this spare cash to paying off an investment loan, your client could effectively earn a higher after-tax return than using a separate cash account. However, paying spare money into the loan reduces the size of the loan. This means if the client needs to redraw cash for non-investment purposes, they can’t claim a tax deduction on the interest charged on the redrawn money.

Depositing spare cash into a 100 per cent offset account linked to the investment loan could potentially be more tax-effective for your client than paying off part of the loan. This is because an offset account is separate to the loan and the client can make repayments without affecting the size of the investment loan or the tax-deductibility of the interest.

Example

By the time Beth turns 45, she’s paid off her home loan. She decides to use some of the home equity to borrow $100,000 at 4.75 per cent per annum to invest in a share fund. Beth recently received a $30,000 after-tax bonus from her employer, which she plans to use to buy a new car in 12 months’ time. Until she purchases the car, she wishes to use the money to reduce her existing interest repayments effectively.

Beth can either:

  • Pay the bonus directly into the investment loan, or

  • Pay the bonus into a 100 per cent offset account linked to the loan

Option 1:

Pay bonus directly into investment loan and redraw $30,000

Beth’s loan balance will drop to $70,000, which means she’ll be paying less in interest. However, when Beth redraws the $30,000 to buy the car, she won’t be able to claim the interest charged on the $30,000 redraw as a tax deduction. She’ll also have a mixture of deductible and non-deductible debt.

Option 2:

Pay $30,000 bonus into a 100% offset account and use offset funds

Beth’s investment loan balance stays at $100,000 and she deposits the $30,000 into an offset account. She’ll still pay the lower amount of interest shown in option 1 because she’s only being charged interest on $70,000 (which is the difference between her $100,000 loan balance and the $30,000 in the offset account).

Things to consider when advising on this strategy

  • Does the client’s investment loan offer a 100 per cent offset account? If not, can it be added? This strategy is only effective with a 100 per cent offset.

  • A line of credit doesn’t generally offer a 100 per cent offset account, and so is not suitable for this strategy.

  • If the client needs money for non-investment purposes and doesn’t have an offset account, it may be more effective to use a separate loan rather than redrawing from the investment loan. It’s also easier to keep track of deductible and non-deductible debt.

  • When the client pays off the home loan, they might consider keeping the home loan account open. They may be able to use the home equity to borrow up to the original pre-approved limit while avoiding stamp duty or registration fees.

Prepay interest

This strategy is best suited for clients with deductible debt who expect to have higher taxable income in the current financial year than the next. By prepaying the following year’s interest expense they may be able to claim a tax deduction for that interest in the current tax year.

Where a loan is used to acquire assets that are expected to generate assessable income, the interest expense is generally tax deductible. The interest is deductible in the year it arises. However, borrowers can pre-pay the interest expense on geared investment portfolios in their own name for a maximum of 12 months and receive an entitlement to the deduction in the current financial year.

Prepaying interest allows an individual to bring forward the tax deduction they may be entitled to in the following year to the current year. This may provide tax-planning opportunities from one year to the next. Many providers offer prepayment at a discounted rate so your client may be able to save further.

Example

Paul’s annual salary is $80,000 and he’s retiring at the end of the year. In addition, he has a $100,000 loan which he’s used to fund part of his investment portfolio. He pays seven per cent per annum in loan interest and his investment portfolio will generate him $13,000 income this year. Paul has been making interest payments steadily through 2020/21 on this loan and has found out he can pre-pay his interest expense for the next 12 months.

The table below shows how much Paul could potentially save by prepaying interest for the 2021/22 income year before 30 June 2021.

Financial position

No prepayment

With prepayment

Salary income

$80,000

$80,000

Investment income

$13,000

$13,000

Assessable income

$93,000

$93,000

Interest deduction for 2020/21

($7,000)

($7,000)

Prepaid interest for 2021/22

Nil

($7,000)

Taxable income for 2020/21

$86,000

$79,000

Tax payable (including Medicare) for 2020/21

$20,137

$17,722

By implementing the prepayment strategy, Paul has reduced his tax liability by a further $2,415.

Things to consider when advising on this strategy

  • The prepayment of interest needs to be made before the end of the financial year in order to be eligible to claim a tax deduction in the current financial year.

  • Once interest is prepaid, it’s not possible to claw back any interest payments if the account is closed or loan repaid.

  • Interest cannot be prepaid for a period greater than 12 months.

  • In an environment where interest rates are falling, the rate at which interest is prepaid may be higher than the interest that may be charged during the next financial year.

Next: Gearing: loan security, gearing level and LVR

Lenders will usually require security to be offered when issuing a loan for an investment. A gearing ratio and loan to value ratio can then be calculated.
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