Case study: An accidental debt scenario
A young Australian couple purchase their first home, and live there for several years, building a happy family and paying down the home loan as they go.
At some point, with a couple of children, they decide to change their home, opting for more space or an upgrade. Because of being able to do so, they decide to keep the former home and convert it into an investment property, so they now own two residential properties.
This is all well and good, except a common mistake is that:
- The former home, now an investment property, has a low debt associated with it
- The new home is almost fully debt funded.
Considering the after-tax cost of debt, this is not an ideal scenario.
As mentioned in our previous blog article “deductible versus non-deductible debt”, it costs more to carry non-deductible home loan debt versus investment debt, especially if you are on a high income.
Let’s assume in our scenario the marginal tax rate for this couple is 39%, and their home loan rate is 3.85%. This means a pre-tax effective rate of 6.31% for their property. They have a high debt against the new home with a pre-tax effective rate of 6.31% and a low debt against the now investment property, which has a lower after-tax cost of debt. This is the accidental debt scenario so commonly seen, the reverse of what is ideal.
What can you do about this?
If you are disciplined with money, and can make an offset account work in your favour to accumulate a large amount of cash within, when you buy the new home, you will be able to simply transfer the cash from the existing home offset account to use as a sizable deposit on the new house. Then the existing home converted to investment property will have a higher proportional debt versus the new home, which will work more effectively than the ‘accidental debt’ scenario described.
One might say why can’t you just refinance your loans to extract money out of the existing home and use it towards the new house? Then the former home now investment property would have a higher loan against it right? Whilst the debt would be higher, the tax treatment is different and inferior, which means this doesn’t solve the issue and defeats the point of the refinance. Be aware we are not tax accountants, so best to check this with your accountant.
You could choose to renovate your existing home and create an ‘upgrade’ to living standard this way. Alternatively, you could choose to sell the old home and then buy the new place you wish to move to with a lower debt, noting that this will mean you will have to pay all the standard costs of selling a property.
A word of warning
Big financial decisions should be multi-faceted, and in some cases, offset accounts are not used effectively at all, putting people into a worse situation. In other words, the theoretical best answer sometimes isn’t the best answer practically. Therefore, it is important to carefully consider how this relates to you, your level of discipline with money, and your situation in general, before making any decisions.
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