For anyone that pays tax, there is a big difference between the price of non-deductible debt and the price of deductible debt. It is vitally important to understand the differences and how they can affect your efforts to eliminate bad debt and create wealth.
Think of the two types of debt as outlined in the following table:
||Tax deduction available
||Also known as
||Your home loan
Non-deductible debt is expensive debt. This is simply because you cannot obtain a tax-deduction on it due to the purpose of the debt.
An example of non-deductible debt would be your home loan or a credit card if you have one. The interest on these debts is not deductible because the purpose of the debt is not to generate assessable income. For example, if you took out a loan to buy an investment property the ultimate purpose is to generate income for yourself (whether it be through rental yield or capital gains). Since that income is taxable in your hands then the associated expenses are then also able to be claimed as a deduction.
How much does non-deductible debt cost?
So there is a cost to holding non-deductible debt (such as the loan for your own home). Since you cannot claim a tax deduction it is reasonable to assume it is a more expensive type of debt.
To put it into perspective, to pay $1 in non-deductible interest you actually have to earn more than $1. This is simply due to the fact that your salary from your employment is taxed BEFORE you can repay debt such as your home loan. The position for an average home loan costing 5% per annum is illustrated below:
||Gross Up Factor
||Pre-tax Equivalent Rate
So if you are an average taxpayer and pay tax at 32.5% (meaning you earn between $37,001 to $87,000) then the pre-tax interest rate on your home loan is actually 7.4%.
People often ask whether they should invest or pay down their home loan. In this scenario, if you choose to repay your home loan you are effectively earning a 7.4% guaranteed return on your money before tax.
Think of it another way. If you decided to invest in shares instead of paying down your non-deductible home loan, then (assuming your tax rate is 32.5%) your shares would need to earn 7.4% to match paying down the 5% home loan. That’s because your 7.4% share return loses 32.5% in taxation.
Obviously the equivalent pre-tax interest rate increases as:
- your marginal tax rate increases, that is, as you earn more; and/or
- interest rates increase. And given rates at currently at historic lows it is reasonable to assume that they will increase in the future.
The second point poses an interesting question. This is particularly so given the extremely low interest rates that clients of Moneybright Home Loans can achieve at the time of writing. Again, assuming you are in the 32.5% tax bracket (income between $37,001 and $87,000), the required rates of return from an investment in say shares would only need to be around 5.5% to 6.3% to make it comparable to paying down your home loan (see table below).
|Home Loan Rate
||32.5% Gross Up Factor
||Pre-tax Equivalent Rate
If you haven’t done so then please visit our Home Loan Refinancing Calculator. One of the options it outlines looks at the possibility of investing the savings from moving to a lower interest rate rather than using the savings to accelerate repayment of the mortgage. When interest rates are low that may be a prudent use of surplus funds for some homeowners. That is, the lower the home loan interest rate, the lower the required pre-tax investment rate necessary to make NOT paying down the home loan worthwhile.
You borrow when you spend if you have non-deductible debt
Let’s extend the principle of the ‘pre-tax equivalent interest rate’ above a little further by looking at it another way.
People with non-deductible debt are borrowing whenever they spend spare money and don’t repay the debt.
Let me illustrate that statement. When you have debt you essentially have two choices as to what you can do with any ‘spare money’:
- use the income to repay some of your debt; OR
- spend the money elsewhere.
Only one option can be taken.
The logical action is to use all of your ‘spare money’ to repay your non-deductible debt. Since there is no tax benefit (via a deduction) in maintaining non-deductible debt it makes sense it should be eliminated as quickly as possible. Whenever you spend ‘spare money’ that could have been used to repay your debt, you are left with a higher debt than you otherwise could have had.
In other words, your spending has an additional after-tax cost in the form of unnecessary interest. That is, you are still paying interest that would have been avoided had you used your ‘spare money’ to repay debt (instead of spending it). This means that you have effectively borrowed to finance that purchase.
An example may help illustrate.
Say you receive a $5,000 tax return and have a $305,000 outstanding home loan. You can either
- repay your non-deductible home loan down by the $5,000 to $300,000; or
- spend the money elsewhere (eg. a new LCD tv).
Let’s assume the interest rate on your non-deductible home loan is 5% and your tax rate is 37%. From the earlier table this means that the effective pre-tax interest rate is 7.9%.
What this means is that for every $1000 you spend on things other than repaying the home loan, you will have to earn an extra $79 every year in income to cover the interest expense of the home loan. In the case of a $5,000 LCD television that is an extra $395 in income you have to come up with every year.
After ten years, this adds up to an extra $3,950 in income.
You have effectively financed the purchase even if it was financed on an interest-free option. By spending on the TV your total debt is $5,000 higher than it could have been and you are paying home loan interest on $5,000 that you could have eliminated.
It’s not much of a life
It’s important to realise that every dollar you spend on not paying down your home loan is not actually wasted. Sure, you could funnel every spare dollar into reducing bad debt such as your home loan and you may even knock it off in a ridiculously short time. However, while that may suit for single people in their 20’s with no family responsibilities, most of Moneybright’s clients are actually young families in their 30’s.
The key point to take away is to understand what financial impact your choices are having on your financial future. For example:
- Does the slight increase in picture quality of the newest curved LCD TV really improve your life?
- Does paying $10,000-$20,000 on a car with a nicer badge really make the school pickup that much more enjoyable?
- and I could go on but you get the picture.
Also recall that the earlier examples assumed interest-free purchases. If you actually finance some of the material purchases in life with a personal loan or credit card then the pre-tax equivalent interest rate can be as high as 27-30% depending on your tax bracket. That is seriously expensive money.
Life isn’t about saving all your money for retirement and then dropping dead nor is it about accumulating an endless procession of ‘things’ no matter the cost. It is about finding a balance that suits you and your family and accumulating experiences.