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.
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.