Capitalising interest in a Line of Credit

When you get a home loan you will often be asked if you want a ‘principal and interest’ loan – where each month you pay interest and a small amount off the principal of the loan. The alternative is an ‘interest only’ loan – where you only pay interest at least for the initial few years of a loan.

There’s a further alternative. You can let interest capitalise although we don't recommend this for owner occupied property it can be useful for investments. It means you can make no payment and let your loan balance gradually rise. To do this you need a line of credit from a lender who does not require regular payments (not all lenders will do this). You also need to make sure that you have not reached the limit of your borrowing – because if you have, the lender will want payment!

Does all this sound scary, it depends on your circumstances. If you watch your finances you might be happy to extend your loan because you believe the asset value of your property is rising - something that needs very careful attention in the current market.

Your investment property finance strategy may include capitalising interest on the investment loan and using the extra cash from not making repayments to allow you to pay other personal expenses for instance repay the home loan. (we strongly advise that you seek tax advice and consider an individual ATO tax ruling before you proceed) in order for this to work the purpose must not be to reduce tax and there is currently some indication that the ATO won't accept where the purpose may be to pay your home of faster. The line of credit into which the interest will capitalise should not be secured against the family home - get some tax advice as the benefits can still be substantial. WARNING The Australian Taxation Office currently has a draft ruling on Part IVA with what can only be described as incredibly wide interpretation on the deductibility of capitalised interest and the use of a line of credit to service investment debt. As a result of this we suggest that you seek urgent taxation advice if you currently use a line of credit to service investment property debt. The draft is supposed to be finalised on 7th March 2012

(Remember the statements made above are general. You should check with your taxation advisor what the situation is with respect to your specific circumstances.)