We’re often asked whether interest only, or principal and interest repayments are the best way to go when it comes to bank loans. While everyone’s personal situation is different, and this will dictate the answer to this question, we must always remember that financially speaking, our primary aim is wealth creation, not tax minimisation. 

Tax minimisation is simply one part of wealth creation, and it is overly simplistic to say that if the interest is tax deductible, then pay interest only to maximise your tax refunds. While there are tax advantages with interest only payments for deductible purpose loans such as rental properties, isn’t your real measure of wealth the amount of equity you have in the asset (the difference between the value of the property and the debt over the property)?

Creating wealth will occur not only when the asset goes up in value, but also when its debt decreases, so generally speaking, debt reduction is a good thing regardless of tax consequences. Debt reduction is hard, so why not do it when interest rates are at historical lows and the amount of interest you are paying is close to as low as it will ever be. You don’t need to have had debt in the 80’s when interest rates approached 20%, to remember how much harder loan repayments can be with high interest rates. Even earlier this decade home loan rates were almost twice what they are now, with interest rates typically in the 8-9% range.

In addition to increasing the equity in your asset, reducing debt now will also reduce the interest you pay later, when the rates might increase. This will reduce the minimum cashflow you will have find in a few year’s time, at a time when increased interest rates are already putting pressure on your financial situation. Building up equity in an asset is also looked upon favourably by banks, and will assist with any future borrowings you might wish get for investment opportunities that come up at a later time.

So if debt reduction is for you, which loans should you apply it to first? This is usually determined by two factors, the effective after tax interest rate, and your cashflow requirements.

The effective after tax interest rate is the interest rate you pay, after allowing for any tax benefit you get if the loan is for tax deductible purposes. In most cases you will want to reduce non-deductible debt first, but this might not always be the case, if you are paying higher interest rates on business or otherwise deductible loans. For example, at the moment you may be paying 4.75% on your non-deductible home mortgage, but have an equipment loan for a work truck that has a 7.5% interest rate on it. If you are currently in the 30% tax bracket, then the effective tax rate on the truck is 5.25% (7.5% – 30% x 7.5%), so you are actually building up more equity by making extra repayments to the deductible truck loan rather than the non-deductible mortgage.

If cashflow may be a concern in the future, then you should also consider the remaining terms of the loans in deciding which loan to make extra repayments to. If you have two loans with identical interest rates and repayment amounts of say $1000/mth, but one will be paid out in 2 years, and the other in 25 years, then for cashflow purposes you will be better off repaying the loan that will expire shortly. This is because paying out this loan will free up $1000/mth, but making an extra repayment on the loan with a long term remaining will only reduce the minimum repayment by a comparatively small amount.

Subscribe To Our Newsletter

Join our Mailing List to keep up to date with all our latest news and tips.

You have Successfully Subscribed!