Tax Effective Loan Structuring

The below case study is just how important it can be to be set up correctly with your home loan.

Case study

* Mr & Mrs Smith - married couple (no children)
* Purchased first home - $400,000
* Borrowed $380,000
* Mr Smith earns $130,000, Mrs Smith earns $20,000
* They are planning to have a family in 5 years and buy a bigger home
* They intend to pay $35,000 in additional payments per year (i.e. at the end of Year 5 - extra repayments in loan = $175,000 - can be used to purchase new residential home)
* They intend to keep this property as investment and rent it out after 5 years

Scenario A Scenario B
Ownership Mr AND Mrs Smith Mr Smith
Type of Loan

Standard Variable Rate.
Principal and Interest

Standard Variable Rate.
Interest Only - Offset A/C
Monthly Repayments $2,611 $2,318
Extra Repayments $35,000 p.a.
Deposited directly into Home Loan Account
$35,000 + $3,516 p.a.
Deposited directly into Offset Account
Loan Balance at end of 5 years $148,393 $380,000
Available funds at end of 5 years $175,000 $231,607
Interest paid at end of 5 years $99,973 $99,973

5 years later ...

Mr & Mrs Smith have a 6 month old son and have used their available funds to purchase a new, larger property for $720,000 (plus $40,000 costs)

Their first property, now worth $550,000, is leased out, and they receive $22,000 per annum - a 4% return - or is it???

5 Years Later

Scenario A
(Principal and Interest Loan)
Scenario B
(Interest Only Loan)

- Rental Income $22,000

- Tax Deductible Interest $10,863 p.a.
(only loan balance of $148,393 will be tax deductable)

- PROFIT from Investment $11,137

- Tax Payable on Profit = $4,288

- Effective annual return = 3.22%

- Net Loss

- Rental Income $22,000

- Tax Deductible Interest $27,816 p.a.
(loan balance of $380,000 will be tax deductable)

- LOSS from Investment $5,816

- Tax (negative gearing effect) = $2,734

- Effective annual return = 4.50%

- Net Savings $7,022

Good Debt v Bad Debt
Scenario A
(Principal and Interest Loan)
Scenario B
(Interest Only Loan)

Good Debt = $148,393 @ 7.32% = $10,863 per annum

Bad Debt = $760,000 @ 7.32% = $55,632 per annum

Good Debt = $380,000 @ 7.32% = $27,816 per annum

Bad Debt = $530,000 @ 7.32% = $38,796 per annum

Published on July 7-th, 2008 in Financial Planning
Damon Rasheed is the CEO of Rate Detective, an Australian financial service comparison sites specialising in Life Insurance, Income Protection Insurance and home loans. Damon holds a Master's Degree in Economics from the University of Melbourne and has been involved in many start-up internet businesses.