Interest only with an offset against PPOR

Discussion in 'Property Finance' started by Jamie M, 12th Jan, 2015.

  1. Jamie M

    Jamie M Mortgage Broker - Oz Wide

    Joined:
    20th Jul, 2009
    Messages:
    4,085
    Location:
    Canberra and Sydney
    A common question that I'm asked and which frequently comes up on the forum is whether a borrower should opt for principal and interest or interest only repayments against their Principle Place of Residency (PPOR).

    For that reason - I thought I'd provide a rundown on the topic.

    I see it every day. Clients who pay down a large portion of the loan on their PPOR and are now looking to upgrade to another house while keeping their current property as an Investment Property (IP).

    So what's wrong with this? In short, when their current property turns into an IP, the loan against this property is generally quite small (as they've paid down a considerable amount of the principal) - which means they can only claim a small amount of interest. The good news is that there's a way around this - but it's important that it's set up correctly from the start.

    Let's look at an example.

    The not so ideal situation
    Jim purchased his first home in 2009. It was a nice little 1 bedroom apartment in the centre of town. He took out a loan of $300k for it.

    The loan was set-up as principal and interest and Jim was determined to pay off his loan as quickly as possible.

    It's now 2015 and Jim has managed to get his loan down to $100k.

    Jim has now decided he would like to buy a larger house but keep his little one bedroom apartment as an investment.

    Because Jim has paid his loan down to $100k - when this property becomes an IP, he can only claim interest on a $100k loan (which is about $5k per annum on 5% interest rates) which isn't ideal since the property is now worth about $500k and is going to get $500 per week rent.

    To make matter worse, Jim wanted to use the equity in his first property to purchase his next one. The issue is that the equity he is accessing from his 1 bedroom apartment won't be deductible because it's being used to purchase a PPOR.

    So in this scenario, Jim has reduced his tax deductible (IP) debt whilst increasing his non-deductible (PPOR) debt. Not ideal!

    So how do we get around this?

    The ideal situation
    If Jim had set up the loan as Interest Only (IO) with an offset from the beginning; he could have eliminated this issue.

    Instead of paying down the principal, Jim could pop all of his spare money (including the would be principle repayments) into the offset account which provides a similar outcome to paying down the principal. Instead of having paid down his loan to $100k, Jim would have $200k sitting in his offset account and only paying interest on the remaining $100k.

    When it comes time to convert this property into an IP, Jim can simply take the funds out of his offset account, which will boost the loan back up to $300k, and use those funds towards his next PPOR. This way, Jim has basically increased his deductible debt (IP loan) back to its original level of $300k whilst reducing his non-deductible debt (PPOR loan) by $200k.

    Now Jim is able to claim interest on a $300k loan (which is closer to $15k per annum on 5% interest rates).

    Please note - this structure (interest only with an offset) works well for those disciplined with money who will make an effort to regularly contribute to their offset account and not just make the minimum interest repayments. For those that are not disciplined with money - principal and interest may be a better option.

    Not all banks are keen on interest only against a PPOR either - so it's important that you use a lender conducive to your requirements.

    All in all - make sure that you plan ahead! Not doing so could wind up costing you thousands.

    Hope that helps someone :)

    Cheers

    Jamie

    This information is of a general nature ? please always consult taxation professionals about the specific nature of your situation.
     
    WattleIdo and The Y-man like this.
  2. rizzle

    rizzle Member

    Joined:
    20th Sep, 2013
    Messages:
    205
    Location:
    Melbourne, Victoria
    Good post, thanks for sharing
     
  3. albanga

    albanga Member

    Joined:
    14th May, 2014
    Messages:
    726
    Location:
    MELBOURNE
    Good post Jamie and very important that you highlighted that this strategy works well for the disciplined. For the not to disciplined this can be very dangerous and whilst I am sure you will enjoy the extra couple of holidays you decided to take because there was over 100k sitting in your everyday offset account, it will be detrimental to your overall investment goals.

    Also one point I would add purely from an investment view is that you should always consider whether turning your PPOR into an IP is the best decision. I see many people do this based purely on emotion (it's a great house, great suburb.etc) but realistically you need to weigh up if you can get a better return elsewhere.

    There is a lot to consider with this such as exit costs and re-entry (No CGT tax though as PPOR exemption) but if your a growth investor and believe you are market peak in the cycle and could cash out and into the bottom of a new growing market then run the numbers and ask yourself are you holding for investment or for emotion.
     
  4. Redom

    Redom Mortgage Broker

    Joined:
    1st Jul, 2014
    Messages:
    1,324
    Location:
    Sydney (West) and Canberra
    With the rise in broker originated loans in recent years, this set up is the norm that brokers use.

    Hence theres been a rise in the 'interest only' loan data.

    The problem is, the regulators dont have a clear handle on the offset account attached to the loan and cant exactly work out how repayments are actually taking place.

    Creates an illusion of massive financial stability problems when it cant be distangled appropraitely by those that make lending market decisions.

    Cheers,
    Redom
     
  5. Liverpool St

    Liverpool St Member

    Joined:
    4th Aug, 2007
    Messages:
    104
    Location:
    sydney
    Jamie,
    Thank you for that post. What are your views on a investment loan with an offset linked?

    LE
     
  6. albanga

    albanga Member

    Joined:
    14th May, 2014
    Messages:
    726
    Location:
    MELBOURNE
    This would depend on whether or not you have any non deductible debt. If you have paid of your PPOR, car loan, credit cards.etc then you need somewhere to store your money and I would almost always say it's better offsetting the interest of an IP over sitting in the bank (even term deposit).
     
  7. Jamie M

    Jamie M Mortgage Broker - Oz Wide

    Joined:
    20th Jul, 2009
    Messages:
    4,085
    Location:
    Canberra and Sydney
    No worries.

    Albanga summed it up.

    If you've got a PPOR loan -then have the offset linked to it.

    If you don't have a PPOR loan - then link up an offset to the IP loan.

    Cheers

    Jamie
     
  8. Redom

    Redom Mortgage Broker

    Joined:
    1st Jul, 2014
    Messages:
    1,324
    Location:
    Sydney (West) and Canberra
    It never hurts having it there Liverpool St.

    But whether its used is about 'return on funds'. Against investment debt, the return is lower as its offsetting deductible debt. Against PPOR debt, the return is higher, as its offsetting non deductible debt.

    If you don't own a PPOR, its a good idea to have one to park transactional funds into. In terms of additional funds beyond day to day transactional, consider the investment offset account return (5% - tax) vs other assets.

    Cheers,
    Redom
     
  9. Liverpool St

    Liverpool St Member

    Joined:
    4th Aug, 2007
    Messages:
    104
    Location:
    sydney
    Thanks all for the replies

    LE
     
  10. Qlds007

    Qlds007 Broker,full time investor

    Joined:
    3rd Mar, 2005
    Messages:
    2,512
    Location:
    Ozwide
    Course as has been mentioned if APRA has it's way such structures may well be a thing of the past.

    Cheers
     
  11. Rolf Latham

    Rolf Latham Member

    Joined:
    2nd Mar, 2001
    Messages:
    18,792
    Location:
    Confused = Sydney, Brisbane and Gold Coast
    well then finally ST George's stuff that they trotted out for 10 years or so about PPOR and IO offset being "illegal" may finally no longer be a silly lie.

    ta
    rolf
     
  12. Qlds007

    Qlds007 Broker,full time investor

    Joined:
    3rd Mar, 2005
    Messages:
    2,512
    Location:
    Ozwide
    To true.

    Guess after 10 years the Dragon might even be right.

    Cheers
     
  13. Jamie M

    Jamie M Mortgage Broker - Oz Wide

    Joined:
    20th Jul, 2009
    Messages:
    4,085
    Location:
    Canberra and Sydney
    Yep - could be interesting times ahead. I'm not too worried at the moment - but will keep a close eye on how things unfold. Also submitting quite a few IO + offsets this week too so hopefully it's all smooth sailing.

    Cheers

    Jamie
     
  14. JT87

    JT87 Member

    Joined:
    20th Jan, 2015
    Messages:
    43
    Location:
    Sydney, NSW
    Thanks for the information.
    I turned my PPOR into a IP which is still PI loan
    Also have a second IP which is PI
    I thought it were a good idea to pay these down whilst renting

    I now see how it is beneficial to pay IO as you have more flexibilty.

    Is there a way to, when purchasing our next PPOR to pull the IP's back to 20% and IO and using that equity in your PPOR?
     
  15. Jamie M

    Jamie M Mortgage Broker - Oz Wide

    Joined:
    20th Jul, 2009
    Messages:
    4,085
    Location:
    Canberra and Sydney
    Hiya

    No worries - glad you find the info useful.

    I'd be converting your current loans to IO now - set up an offset against one of them and park all your savings in it.

    When it comes time to buy your next PPOR - use the funds from the offset to cover the deposit/costs.

    If you need to use equity from an IP - then make sure it's set up as a separate loan account.

    Hope that helps.

    Cheers

    Jamie
     
  16. lawmich

    lawmich Member

    Joined:
    23rd Jul, 2014
    Messages:
    53
    Location:
    Sydney
    Good reading.

    My broker thinks it's better that we hold more cash by using a IO against PPOR.

    At the moment, my PPOR is IO loan only with quite a bit of money in offset which ensures my interest payment is low.

    I now want to build a granny flat and my broker thinks i should get a IO investment loan for it even though i won't be renting it in 5 or more years. My broker thinks that if i decide to move on and convert my current PPOR and granny flat into investment, then there will be good deductions.

    Sounds about right? Getting a loan just for granny flat rather than paying it with money in current offset account?
     
  17. Tranquilo

    Tranquilo Member

    Joined:
    3rd May, 2014
    Messages:
    232
    Location:
    sydney
    Hi Jamie. If Jim was neutral or positive can he still claim that interest?.
     
  18. Rolf Latham

    Rolf Latham Member

    Joined:
    2nd Mar, 2001
    Messages:
    18,792
    Location:
    Confused = Sydney, Brisbane and Gold Coast
    smart broker, but also check with your accountant

    ta
    rolf
     
  19. Redom

    Redom Mortgage Broker

    Joined:
    1st Jul, 2014
    Messages:
    1,324
    Location:
    Sydney (West) and Canberra
    Agree - smart broker! Its a good idea - best to borrow if you've got the equity there.

    The borrowed equity that's used for investment purposes is deductible. Given your offset funds sit against non deductible debt, using your $100k in cash will not be deductible.

    Borrowing leads to about $5000 more in deductions a year...which adds up pretty quickly.

    Cheers,
    Redom
     
  20. lawmich

    lawmich Member

    Joined:
    23rd Jul, 2014
    Messages:
    53
    Location:
    Sydney
    Thanks guys. My broker is also a qualified financial planner thus I consider his views more seriously. I am.hesitant to take up too much loans but his suggestion makes a lot sense.