By CHRIS BATES
As a financial planner, my role is always to be thinking about the best strategy and path for my client to take. Since I’ve been working very closely with mortgage brokers for many years, I’ve realised the vast majority of brokers (and to a greater extent bank employees) don’t take the same strategic view.
Being a somewhat transactional role, most mortgage brokers take the line of least resistance to get the deal done. Whether they understand structuring strategies or not, very few take the time to educate their clients on the pros and cons of different decisions and how to make the most of their situation. In reality, they’re also limited by compliance standards in some cases.
This can become very confusing and challenging for new clients to get their head around.
Whether you should choose to go ‘interest only’ or ‘principal and interest’ is a question every borrower needs to consider and answer when taking out a home loan. Naturally we rush to find an answer, but before you make that decision, it’s important to truly understand it.
Our first response tends to be ‘principal and interest’. Our parents, grandparents and society all tell us that debt is bad and we need to repay it – and that’s true to a certain extent.
So, why would I go interest-only when I want to pay my debt down?
The truth is you can pay your debt down and a whole lot more by choosing to take an interest-only loan with offset account.
There are some for whom it’s better to go principal and interest. These are generally borrowers who don’t have their cash flow under control and feel like they need to be forced to save. This is the only benefit of going principal and interest – the bank forcing you to save. I know I’d prefer to choose what I do with my money each month and if I want to pay my debt down, I will. If I need to just pay interest this month or use this money to cover short-term additional expenses, I will.
So, how does it work?
Firstly, it’s important that when you set up the interest-only loan, you also open an offset account linked to the loan. These are usually included for free with any package loan from a bank. An offset account does exactly that – offsets your loan account. For example, if you had a loan of $500,000 and you had $20,000 in your offset account, in reality you only owe the bank $480,000. When they calculate your interest due for that day, you’ll only be charged interest on $480,000 owing, not $500,000. Without trying to drum the point home further, if you happened to put another $20,000 in your offset account, you would only pay interest on $460,000.
The offset account is, I believe, the best invention and tool in the financial planning world. I absolutely love them. They give my clients complete flexibility in what they’d like to do with their cash flow and savings. We use this as a “savings account” that will always be getting a greater return than any other savings account. It’s completely assessable and can be moved wherever needed. So, if you don’t have an offset account, I suggest you get one and, secondly, understand how to best use it.
So, if the key to paying down debt each month isn’t by principal and interest each month, how do I do it?
I ask all my clients to reassess their lifestyle expenditure every year. This allows them to see what income they’re likely to earn and what their expenses are going to be this year. On the back of this we choose an affordable amount and then clients commit to this for 12 months straight.
Each month this amount goes into the offset account and when interest is due, the bank takes it out of the offset account. Whatever’s left over is built up in that offset account and means less interest is paid the following month.
By growing the offset account as much as possible, we’re reducing the interest due and that means we can grow the offset account even further. Each year my clients’ goal isn’t to pay down their debt by $50,000 but rather to increase their offset account by $50,000, for example.
The key benefit to understand is that interest is calculated daily and you’d be in the exact same position financially if you decided to save the same amount each month and pay via principal and interest.
For instance, if you took two routes over 10 years and saved the exact same amount on a debt of $500,000, on one route the debt may now be down to $300,000 and on the other the debt would still be at $500,000 but you now have $200,000 in an offset account.
At this stage you might ask, ‘what’s the benefit?’
There’s no obvious benefit, but I can assure you, you’d always want to take the debt of $500,000 with $200,000 in the offset account and I’ll explain why.
To make sure we’re on the same page, the key takeaway here is that you can still repay your debt via interest-only but the difference is, it’s your choice to do so, not the bank forcing you to. Instead of reducing your loan every month, you’re aiming to build your offset account up.
Why I don’t like principal and interest (P&I) loans
- Separating debt – by going interest-only on all loans, you keep the original debt at that level forever. You then put any leftover savings in an offset account against any debt that’s not tax deductible. This flexibility means you can move your savings around to whichever debt is not tax deductible at the time and it also clearly separates your debt. If you decide to move to another property you own, you transfer your offset account to a different loan and this will save you a lot of tax.
- Lower commitment – on a P&I loan the minimum payment due to the bank each month is roughly 20 per cent higher on a 30-year loan. In reality, if you can’t afford that 20 per cent you’ve probably got too much debt, but why would you force yourself to a higher commitment? Personally, I’d prefer to have a minimum payment 20 per cent lower and choose to save more into my offset account.
- False pretences – I also believe that paying the minimum payment each month gives clients the idea that that’s the amount they should pay per month. The bank wants you to take as long as possible to pay this debt down, which is why they give you loans for 30 or 40 years. Do you really want to have a loan for 40 years? The best way to pay your debt down is to pay as much as you can afford each month by undergoing a detailed lifestyle questionnaire every 12 months. Disregard what the bank minimum payment says as that’s not what matters. Just save as much as you can above your interest only amount per month.
- Flexibility – the problem with paying the extra 20 per cent and more every month, is that this begins to add up over time. There may be times in your life when you can’t afford your minimum repayment each month and you don’t have any buffer built up as you’ve paid it all into the loan. By paying this amount into an offset account instead, you’re building your buffer every month and if you can’t pay one month, that’s OK – you have money in the offset account to cover it.
- Home becoming an investment property = tax savings – the ATO states that once you pay down your debt you can’t redraw on that debt and get a tax deduction unless it’s for investing purposes. In the example above, because the debt has never been paid down, if you moved out of the house and decided to use it as an investment property, the tax deductible would be at $300,000 and not the original loan of $500,000. A big difference and, at current interest rates, you’d be $4000 a year better off in tax.
- Home purchase in future – it’s very likely that you’ll purchase a new home in the future and this debt will not be tax deductible as it’s your principal place of residence. What you need at this point in time is cash or equity to cover the 20 per cent deposit and costs. But what you’d also like is to put every single dollar you’ve saved over the many years beforehand into an offset account against this new debt. If you pay down your loans via principal and interest, you can’t get this money back to put into the new offset account. If you have it sitting in an offset account, you can move it straight away and get the tax benefit.
These are the reasons I challenge you to rethink how you structure your loans. It’s simply a mental mind shift and that’s all. Once you understand it, you’ll still pay down your loans just as you were, and just as fast, but you can do this by having a focus to increase your offset account.
I can’t stress the benefit of going interest-only and using an offset account enough. By not doing this, I’ve had many clients who’ve been forced to sell homes that they would have kept if they went interest-only. I’ve seen clients been able to keep their homes through financial tragedies due to having a buffer and I’ve seen clients pay down their debt faster by staying disciplined to the amount they can afford and not what the bank tells them to repay.