Q re paying interest in advance yearly

R

raoul

I have a question about something in Jan's book "More Wealth" on p171 about paying yearly interest in advance. Jan gives an example of 8% in arrears (monthly) being equivalent to 7.36% in advance when paid yearly in advance. She also states that the in advance rate should be better than that to make it attractive.

I'm afraid that I have to admit that even after thinking about this at length, I don't understand why it needs to be 7.36% or lower.

And I am in a rush to understand it because I just signed for a house in Wellington Point (QLD) and I need to choose loan type and period.

At the moment, I am favouring an IO (of course) with the interest rate fixed at 6.79% for 5 years. I have the option of pre-paying the year's interest in advance and getting the rate down to 6.59%. This is a difference of 0.2% between the in arrears and in advance rates.

However, Jan's comment about the difference needing to be more worries me that I have not understood something fundamental and I'm about to make a mistake.

I do wish to go with the year in advance payment because it will help reduce the effect of a large CG event this tax year.

Comments and advice would be most gratefully received.

cheers

raoul

PS: I'm also worried about the Real Estate Agent's commissions for collecting the rent. The RE agents managing my two rental properties in Melbourne only charge 7%+$24 for statements, but the two quotes I've had from local agents in Wellington Point want 8% and 8.5%.

I am mindful that Jan said somewhere to nuture relationships with PMs and tradespeople, but how do you that while stopping people taking advantage of you...

What do other people pay in commission to their PMs?
 
Hi Raoul,

I was quoted 8.5% - 9% for 5 properties i have managed by 1 PM in QLD, i negotiated it to 5.5%. It seems to be the rate in QLD as i have property managed in NSW at 6.5% with no negotiation which is about the standard rate here. (or 7%)

You can try to negotiate them down but with 1 property they probably wont come to the party.

____________________________________________________

While i havnt done it with my IPs, i do it for commercial vehicle loans for my company (pre pay all interest in June of this year for the whole of next year but claim the payment as a deduction for this year)

I think its called the "13 month rule" and the tax office want to see a commercial reason and not a tax avoidance reason to prepay so much money, so the commercial reason is the offer of a lower interest rate your bank will give you to pay so much in one lump sum.

Its hard to stuff it up, you just have to calculate your next 12 months payments and pay it in one go. (or see your accountant)

I havnt read Jans books yet so i might be waffling on a bit, (just relating my experience with it) maybe a financial guru on the forum can answer you more specifically
 
Hi Raoul

I guess you might also want to take into account the cost of not having the use of that money for 12 months. If it was going to be under your mattress for 12months then the calculation is easy. However you might also want to use that money for improvements, additional purchases or other investments.
 
That's true, but the money will be coming from a drawdown against another IP, so it will boost that loan's interest as well. So, I get a double deductable benefit.

(The extra money was paid into that loan when we sold our house and moved overseas several years ago - the bank made us do that to keep the LVR within their specs - unfortunately, it pushed it where the property sometimes is positively geared depending on vacancies, interest rates, etc)

thanks again
 
"I guess you might also want to take into account the cost of not having the use of that money for 12 months. If it was going to be under your mattress for 12months then the calculation is easy. However you might also want to use that money for improvements, additional purchases or other investments"

If thats all the money you have and you'd have to borrow money for improvements,additional purchases or other investments, then its no use doing it, its only useful if you have a car boot full of cash and you can just dump a lump sum on interest payments to minimise your tax for that particual year (did i say that?).


If you have to borrow the money to do that then dont worry about it........
 
Thanks for your input, but I'm sorry Brains, I don't follow you.

No, I don't have a bootload of cash - I still have a home loan to pay off.

However, this tax year, I sold an IP and my rough calculation is that I will have to pay $35,000 CGT. (At the moment, that money is sitting in a 100% offset account working for our home loan until the current tax year is over and the ATO determine how much I have to pay.)

Yes, I will be increasing a loan to pay off a loan. However, that loan has $35,000 extra money tied up in it because the bank made us put it in to the loan when we sold our home to move overseas. I can drawn some of this down to use for investment purposes, but I can't draw it down to pay off our home loan because that would be for personal use and not tax-deductable.

So, if I can prepay my deductions go up relative to my total income, thefore my $35,000 CG tax should drop a bit.

Have I missed something?
 
Dear Raoul,

The banks charge lower interest rate on pre-paid loans not to give you an excuse for claiming a deduction, but because they are getting the money sooner which leads to more profit by lending the money to other people.

In fact, it is the same principle as with term deposits - annual rate may be 5% if interest is paid annually, but only 4.85% if paid monthly. In this case the bank parts with the money earlier hence a lower rate.

Say cheese :p

Lotana
 
Lotana,

Its not an excuse for a tax deduction by the bank but it is the commercial advantage the ATO likes to see if they question why you did it.
 
Originally posted by raoul
I have a question about something in Jan's book "More Wealth" on p171 about paying yearly interest in advance. Jan gives an example of 8% in arrears (monthly) being equivalent to 7.36% in advance when paid yearly in advance. She also states that the in advance rate should be better than that to make it attractive.

I'm afraid that I have to admit that even after thinking about this at length, I don't understand why it needs to be 7.36% or lower.
Click to expand...

Hi Raoul,

One can talk about the effective annual interest rate i paid in arrears, and the rate of discount d, which is paid in advance, where d is really the present vaue of the interest payment i received at the end of the given time period (one year), i.e.

d = i/(1+i)

If the interest rate is calculated monthly then then it satisfies the equation (with p=12)

(1+i) = [1 + i^(p)/p]^p

or

i^(p) = p*[(1+i)^(1/p) - 1]

and we also have

(1-d) = [1 - d^(p)/p]^p

or

d^(p) = p*[ 1 - (1-d)^(1/p)]

Now in the example above we have
"8% in arrears (monthly)" which I take to be i^(12) = 0.08.

And we want d...

so i=0.0830, and d = 0.07664.

They doesn't match with their figure of 0.0736?

If instead they mean i = 0.08, then d = i/(1+i) = 0.074, which is closer but still not the same?

It may be a typo?
Someone please prove me wrong!!

Anyway, it's all about the time value of money.
Receiving/paying money at a discount rate d now is the same as receiving/paying money at an interest rate i in a year's time.
The payments are equivalent.
So if you can pay less/receive more than the rate d now then you will be better off.

cheers, Tony
 
Originally posted by raoul

So, if I can prepay my deductions go up relative to my total income, thefore my $35,000 CG tax should drop a bit.

Have I missed something?
Click to expand...

I think you can only offset a capital gain with a capitail loss.
If you can lower your tax rate for the year of the gain you can ease the pain some :) by paying at a lower tax rate.

bundy
 
Hi Bundy,

I think you can only offset a capital gain with a capitail loss.
Click to expand...

Hmm. That would make my tax accountant wrong... He said that after calculating the capital gain from the IP I sold, 50% of the CG would go on top of my taxable income and be taxed at that marginal rate (the top rate). Hence my desire to heap up the deductions this year by paying a year's interest in advance.

Anyone else know for certain?

By the way, thanks to everyone for their responses - I've picked up a few new things (except for Tony's answer which left me wondering what happened to my mathematical ability...) However, I don't think my original question has been answered. Why does Jan say that paying a whole year's interest in advance would have to be at a rate where the difference between the in arrears and in advance is that is much greater than what the banks offer. Makes me think the bank is making fun of economics-challenged engineer's brain...

cheers
 
The interest payments upfront would lower your income for the year.....if you make it under top tax rate you can save some money if not there is not much incentive to pay upfront.

Take a look at www.ato.gov.au and learn about cgt yourself.

Then maybe find a new accountant :)

bundy
 
"d = i/(1+i)

If the interest rate is calculated monthly then then it satisfies the equation (with p=12)

(1+i) = [1 + i^(p)/p]^p

or

i^(p) = p*[(1+i)^(1/p) - 1]

and we also have

(1-d) = [1 - d^(p)/p]^p

or

d^(p) = p*[ 1 - (1-d)^(1/p)]

Now in the example above we have
"8% in arrears (monthly)" which I take to be i^(12) = 0.08.

And we want d...

so i=0.0830, and d = 0.07664.

They doesn't match with their figure of 0.0736?

If instead they mean i = 0.08, then d = i/(1+i) = 0.074, which is closer but still not the same?"



huh???????.......................:)
 
G'day Raoul,

You said:-

I do wish to go with the year in advance payment because it will help reduce the effect of a large CG event this tax year.

Watch out here, Raoul - I tend to agree with others who say that only a capital loss can offset a capital gain - (got any shares that have lost money that you really don't want to keep?? Sorry, Eric ;) )

Please note, my opinion following could be WRONG - but the way I believe it works, is that your Taxable Income (from ordinary sources) is calculated, then 50% of any Capital Gains is added, and only THEN is Tax to be paid calculated!!! Keep quizzing your Accountant until you understand it all (then let me know, will you ;) )

My major point here, Raoul, is that I think you would have to reduce your taxable income BELOW $25k before you would see ANY benefit wrt the Capital Gain. Why? Well, that is because the Capital Gain will be added straight onto your income. So, if you are earning (say) $40k, and you race around to gain deductions, and manage to get your taxable income down to $30k, it HASN'T HELPED A BIT !!!! (At least, as far as CGT is concerned)

With taxable income of $30k, add on the capital gain, and your taxable income is now $65k - guess what? Top marginal rate !!! So, by getting taxable income below $25k, and adding CGT on, your taxable income is now (say) $59k, so your tax rate NOW drops to 44.5% instead of 48.5%.


Do you have any "dog" stocks that you were wanting to be free of?? They could help......

Regards,
 
Raoul,

My understanding of your situation is that this year you are going to have a big tax bill. You have your normal taxable income plus your CG, you can't change the CG event but you can change your taxable income by maximising deductions.

If you prepay interest this year you are simply moving the deduction from next year to this year, of course you can prepay a year next year if you wish.

But , this year you have a bigger bill than normal so find as many
deductions as possible in this year.

Your accountant should be able to easily and quickly demonstrate it is best to pay the interest this year.

Macca :)
 
I agree that having a larger interest bill this year will maxmise the deduction, hence reduce the taxable income, ultimately resulting in a reduced tax bill.

I look at it like this:

Let's say the loan is $100K. At 6.79% the yearly interest bill paid in arrears is $6790. At $6.59% paid in advance the yearly interest bill is $6590. Clearly a $200 saving for prepaying a year early.

How much could you earn on the $6790 if you had the use of it for 12 months? Could you earn *more* than $200 to make up for the saving you gained by prepaying your interest one year early?

I could put $6790 in an ING savings fund for 12 months, get 4.75% interest, which would yield $322 approximately. If I gave half to the tax man I would earn a real $166, which on face value is not as good as the savings I get from the loan.

But since IP interest is tax deductible, the real $200 I save is really only worth $103 to me at the top marginal rate ($200 x 48.5). So, allowing for the tax deduction I would have got if I had paid the extra $200 in interest, the $200 in interest has an after-tax cost to me of $103 to me, and the ING savings interest has an after-tax benefit for me of $166. Clearly putting the money in ING for a year is the better choice.

Let's say I put $6790 in an offset account at 6.5%. I earn $441 in saved interest over the year, more than double the savings I have made by prepaying by interest. Once again, because IP interest is tax deductible anyway, this is worth a real $227 at the top marginal rate, once again better than the $103 real cost of prepaying the interest.

Every subsequent year, my offset account would earn me $441 compared to saving $200 at the lower "year-in-advance" interest rate.

Money that you save via strategies like offset accounts and lower interest rates don't appear on your tax return, so this is a genuine apples-to-apples comparison in my opinion.

So, assuming you can place the in-advance monies in an offset account bearing the same interest rate as your "in-arrears" IO loan, then the "prepay yearly in advance" interest rate HAS TO BE <roughly> AT LEAST 6.79% * 6.79% = 0.46% BETTER for you to gain from it over the offset account technique (this of course depends on the interest rate you earn from the offset account).

Look at it another way:

With the bank only offering only 0.2% better *the bank* could be loaning your $6590 prepayment to someone else at the original 6.79%, which earns them $447 in interest, they lose $200 in giving you the interest rate discount of 0.2%, and they are still $247 ahead!

But if the bank was giving you a discount of 0.46% (therefore 6.79-0.46% = 6.33%) for prepayment, then the bank could be loaning your $6330 to someone else at the original 6.79%, which earns them $447 in interest, but they lose $460 in giving you the interest rate discount of 0.46%, and now they are slightly behind.

Back to the tax/CGT issue (continuing the $100K loan example).

The best saving you can make tax-wise is you will get a refund on the prepaid interest claimed as a deduction. At the highest marginal tax rate of 48.5% this means the best savings you can achieve is $6590 * 48.5% = $3196.50.

If your CGT "bill" is $35K the best the above scenario will do is reduce that bill by $3196.50.

But every year, you have been losing $441-200 = $241 in potential savings resulting from having that $6590 in an offset account. As already noted, because IP interest is tax deductible this equates to a real loss of about $124.

So, if you prepay your yearly interest bill using the 6.59% rate, you are "losing" a real $124 per year at the highest marginal rate, but in doing so you are gaining an up-front one-off "real" saving of $3196.40 in terms of your tax bill.


If you are in fact borrowing the year-in-advance interest payment, then ignoring the tax implications produces virtually the reverse situation to the offset account example, above:

For example, if you borrowed the $6590 prepayment amount at 6.5%, that borrowed money costs you $428.35 a year in interest. The $100K loan at 6.59% cost $6590 per year in interest, and the 6.79% loan costs $6790 per year in interest.

Prepaying the interest one-year in advance, using borrowed money, means the total interest is $6590 + $428.35 = $7018.35. If you pay the interest in arrears, thereby avoiding the borrowing of the $6590, your total interest is $6790. By prepaying using borrowed money you have paid an extra $228.35 per year in interest.

That interest is tax deductible, so the "real" cost to you (after tax) at the top marginal rate is $228.35 - 48.5% = $117.60.

As far as the tax savings go, the $6590 prepayment produces the same $3196.40 tax refund at the top marginal rate.

Once again you have the decision between losing $120-approx per year "real" money" in favor of gaining a $3196.40 tax "refund" or offset against your other tax.

Keep in mind, however, that there may come a time when the property is sold and since you have prepaid the interest at settlement time you might be entitled to a refund of the interest. Not sure whether this refund is treated as "income" or what, but if it was, you would be paying tax back on that income, which somewhat negates the savings you made in the first place.

This does not negate the benefit of such a technique, necessarily, because even $3196.40 today is worth a lot more than having to pay an extra $3196.40 back in tax in 20 years time.

Kevin.
 
Dear all,

I think there may be a minor confusion with Raoul's phrase

"I do wish to go with the year in advance payment because it will help reduce the effect of a large CG event this tax year."

As some correctly noted, deductions will not decrease his CGT, but will decrease his total tax.

IMHO the confusion might've been caused by the fact that capital losses cannot be offset against ordinary income, but the reverse scenario that Raoul is suggesting is perfectly fine - ordinary deductions will reduce the total tax paid whether a CGT event exists or not.

Say cheese :p

Lotana
 
My god Kev, what an awesome reply. You could print that, bind it and sell it in API mag for 20 bucks.......
 
He He. $20 bucks? I think I'd prefer to contribute my mathematics/logistical skills to these forums rather than a magazine, given the value I've received in return.

I would feel more secure, nonetheless, if DaleGG cast his eye over it...

Kevin.
 
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