Deductible vs non-deductible debt
Some consider it a nasty word: debt.
However, not all debt is created equal.
There are two types of debt one can hold when considered from a tax perspective; deductible and non-deductible debt.
Non-deductible debt in Australia includes your home loan, any car loans and personal loans.
Deductible debt is that debt where a tax deduction can be claimed. Where a loan is taken out to purchase an asset or assets that will generate an assessable income, then it can be deductible. Such as the loan on your investment property or the loan used to purchase a portfolio of investments. Your accountant can confirm tax deductibility for you.
In order of priority, it is generally more effective to pay off non-deductible debt first.
Why? Because in paying for the non-deductible home loan, you are using after tax dollars to repay it, which means it has a higher after-tax cost versus deductible debt.
If we assume your home loan rate is currently 3.85%, and that you are on the marginal tax rate of 39%, your effective pre-tax interest rate is 6.31%. So, the after-tax cost of non-deductible debt in your case here is 6.31%.
This is worked out as follows:
Interest rate / (1 – Marginal tax rate)
3.85% / (1 – 0.39) = 6.31%.
If the same loan was for an investment property, because the debt would be tax-deductible, the cost of debt is effectively less.
Therein lies a key difference and reason to focus on reducing non-deductible debt first.
Let’s be clear here, ultimately many people aim to be totally debt free, but as you can see from the above, the order and after-tax impact is a worthy consideration.
As with many personal finance matters, it is important to understand the particular context of your situation, and where relevant, seek advice that is specific to you.
General advice disclaimer: The information provided in this article (including taxation) is general in nature and does not consider your individual circumstances or needs. Before acting on this information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. Where applicable, you should read the relevant product disclosure statement and seek personal advice from a qualified financial adviser.
The views expressed in this article are solely those of the author; they are not reflective or indicative of Millennium3 Financial service’s position and are not to be attributed to Millennium3. They cannot be reproduced in any form without the express written consent of the author.
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Disclaimer: Millennium3 Financial Services Pty Ltd ABN 61 094 529 987 AFSL 244252. The information provided in this document is general information only and does not constitute personal advice. It has been prepared without taking into account any of your individual objectives, financial solutions or needs. Before acting on this information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. You should read the relevant Product Disclosure Statements and seek personal advice from a qualified financial adviser. From time to time we may send you informative updates and details of the range of services we can provide. If you no longer want to receive this information please contact our office to opt out. The views expressed in this publication are solely those of the author; they are not reflective or indicative of Licensee’s position, and are not to be attributed to the Licensee. They cannot be reproduced in any form without the express written consent of the author.