With Interest Rate Hikes on Interest Only Loans, Should Principal & Interest Repayment Be Made on An Investment Mortgage

I am not an expert in taxation and would be open to remarks if my assertion below is incorrect.

Historically, most households with multiple properties make principal & interest repayment on the owner-occupied mortgage and interest-only repayment on investment mortgages. An investment mortgage is cheaper after factoring for tax distortion (interest accrued from an investment mortgage is tax deductible), hence the focus in repaying the owner occupied mortgage.

The issue has been complicated in recent months. With the government putting a quota on the sale of investment and interest-only loans, lenders charge a significant premium for investment loans on interest only repayment. Investors are now querying whether principal + interest repayment should be made on the investment mortgage. 

Notwithstanding the higher interest rate, it may be viable to maintain interest-only repayment on an investment mortgage for a borrower on average income and with a negatively geared property. The following variables are used to form this opinion:    

1.

Borrower on $87,001 - $180,000 i.e. highest marginal tax rate of 37%

2. 

Borrower owes $500,000 each on both the owner occupied and investment mortgage

3.

For a $500,000 mortgage on P+I repayment over 30 years, the principal component of the repayment is:

·        $8,803 in the first year

·        $17,966 in the second year and

·        $27,456 in the third year

The principal component of repayment is the same regardless of the interest rate charged

4.

Both owner-occupied loans and investment loans are with the Commonwealth Bank on a standard variable rate (SVR). Borrowers is getting 1.30% discount on the owner occupied mortgage and 1.00% on the investment mortgage i.e.:

·        CBA’s owner occupied SVR on P+I repayment is 5.22%. With 1.30% discount, the rate applicable is 3.92%

·        CBA’s investment SVR on IO repayment is 6.24%. With 1.00% discount, he pays 5.24%.

·        CBA’s investment SVR on P+I repayment is 5.80%. With 1.00% discount, he pays 4.80%.

If the Investment Mortgage is Switched to Principal + Interest Repayment

In year 1,

i)

The principal amount on the owner-occupied loan would be $8,803 more as $8,803 is channelled towards investment mortgage repayment. $345 more in interest is payable on the owner-occupied mortgage, being $8,807 * 0.0392%.

ii)

The investment loan principal amount would be $8,803 less at the end of the first year. $3,258 of tax deduction may be foregone, being $8,807 * 37% highest marginal tax rate

iii)

$2,623 less in interest will be accrued for the investment mortgage, calculated by:

Original Payment $500,000 * 5.24% = $26,200

Less

Adjusted Payment when paying P+I on Inv. Mortgage $491,193 * 4.80% = $23,577

The disadvantage in making principal + interest repayment on the investment loan is $980, being $345 + $3,258 - $2,623

In year 2,

i)

The principal amount on the owner-occupied loan principal amount would be $17,966 more as $17,966 is channelled towards investment mortgage repayment. $704 more in interest is payable on the owner-occupied mortgage, being $17,966 * 0.0392%

ii)

The investment loan principal amount would be $17,966 less at the end of the second year. $6,647 of tax deduction may be foregone, being $17,966 * 37% highest marginal tax rate

iii)

$3,062 less in interest will be accrued for the investment mortgage, calculated by:

Original Payment of $500,000 * 5.24% = $26,200

Less

Adjusted Payment when paying P+I on Inv. Mortgage $482,034 * 4.80% = $23,138

The disadvantage in making principal + interest repayment on the investment loan is $4,289, being $704 + $6,647 – $3,062

In year 3,

i)

The principal amount on the owner-occupied loan principal amount would be $27,456 more as $27,456 is channelled towards investment mortgage repayment. $1,076 more in interest is payable on the owner-occupied mortgage, being $27,456 * 0.0392%

ii)

The investment loan principal amount would be $27,456 less at the end of the third year. $10.158 of tax deduction may be foregone, being $27,456 * 37% highest marginal tax rate

iii)

$3,517 less in interest will be accrued for the investment mortgage, calculated by

Original Payment of $500,000 * 5.24% = $26,200

Less

Adjusted Payment when paying P+I on Inv. Mortgage $472,544 * 4.80% = $22,683

The disadvantage in making principal + interest repayment on the investment loan is $7,717, being $1,076 + $10,158 – $3,517

Qualification

The above outcome may vary dramatically if:

·        the property is positively geared where rental income outweigh interest accrued from the mortgage e.g. <60% lend mortgages

·        the borrower is on a lower income tax bracket

·        the household does not have an owner occupied mortgage

Conclusion

Many borrowers are fixated with getting the cheapest interest rate.   It is impossible to obtain the cheapest interest rate indefinitely as rates fluctuate frequently. Many lesser, usually smaller lenders can offer phantom rates to entice new customers, thereafter increasing the rates substantially. Putting thoughts on effective tax restructuring and prioritising repayments may reap more benefit over time.

Important Information

This above is opinion and not professional taxation advice. Our office is neither accredited nor insured or remunerated in providing taxation advice. To the extent permitted by law, I cannot be held liable for any loss or damage incurred by any person as a result of relying on the above content. Our office offers credit advice only. Please liaise with your tax accountant or financial planner for taxation or financial planning recommendation.

RT 10/7/17

Posted in: Interest rates

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