More reasons to fix and to accelerate your deductions
(with interest in advance)
Newsletter 2006

It's still a few months till the end of the financial year, but now is the time to start thinking about it.  Each year there's a big rush of applications and lenders often close their books a few weeks before the end of June to get all the work done.

You should consider the interest in advance option each year, for its unique tax advantages. By paying next year's interest early you can claim the deductions one year early too.

This year interest in advance (IOA) offers unusual value for two special reasons. 

1.      Taxes are falling in July this year.  So by paying in advance, you maximise your interest deductions against higher tax rates and minimise it when tax is lower.  Many of those earning over $63,000 per year are likely to gain additional benefits by maximising this year's tax deductions, though individual circumstances will differ.

2.      IOA loans are on a fixed rate.  And as previously discussed, fixed rates are unusually low given that the Reserve Bank's bias remains to raise rates.  And as an economic consultant I receive lots of e-mails each week outlining various economy watchers' views on rates.  I attach an email I received from Rory Robertson, Macquarie Bank's Interest rate strategist, where he outlines his reasons for changing his mind on rates (arguing now that they're headed up). And this was before very strong employment news came in, which would have strengthened his arguments for a rate rise.

So paying interest in advance before June 30 this year is effectively killing two birds with one stone.  As usual we've built a special calculator to cut through the complexities and given you an indicative snapshot of what it's worth to you.

Give us a ring and we'll send you a full no-obligation report outlining the indicative savings you can expect (if any) with IOA.

How it works:

If you've paid interest monthly in arrears this year and now pay all of next year's interest in advance before June 30, 2006, then you will in most normal circumstances effectively claim two years' deductions in one year.*

You can keep doing this in future years - instead of claiming two years' interest this year and no interest next year, you can pull forward interest payments again next year and each year after that. The total amount of tax refunds will generally stay the same but you'll get them sooner. In effect, it's a free loan from the government. And the "loan" from the government can stretch out a long time.

Paying interest in advance can be particularly advantageous if the tax rate you'll pay next year is lower than your rate now.  As explained, tax cuts are likely to make this the case if you earn over $63,000, but it may also be the case if you think you're taxable income will fall next year - if you're going on a break, going part time, having a child or whatever. 

You might also be able to use the year your interest payments are minimised for an "interest pause" in case you need some breathing space in the event of an unexpected drop in income or change of personal circumstances.

So, paying interest in advance could effectively save you thousands.

Downsides

Before we look at some examples, there are downsides that should be considered.

You'll pay your interest earlier, so you incur your expenses as well as get the benefits of tax deductions sooner, although generally your free kick from the tax office can be organised fairly quickly after the financial year, with your refund put into your mortgage. 

Also fixing lowers risk, but risk isn't all bad. There's upside risk and downside risk. It's possible you'll fix for the next year only to find rates actually fall.

I think that a drop in rates is somewhere between unlikely and very unlikely in the next financial year, and most economists think that any move in rates will again be up rather than down, but none of us have crystal balls.

How to Proceed

Contact us right away, so that we can provide you with some calculations and some ideas. We've been scanning the market for the most competitive interest in advance loans, so you can pick our brains. And if you refinance your loan through Peach, you can pick our pockets too.

Our normal rebates still apply. That's $1,000 or more back to you for most many loans over $300,000 and generous rebates for loans from $150,000 - unless you got a loan from us in the last three years in which case reduced or zero rebates may apply.

Example: Susan

Here's an example of a hypothetical property investor, Susan, who is thinking about paying interest in advance.  She currently has a loan with a balance of about $350,000 and variable interest rate of 6.60%.  Susan is considering switching to a 3 year fixed rate IOA loan with a rate of 6.45%.

If Susan chooses the interest in advance (IOA) option and claims the interest this financial year then her marginal tax rate for the year will fall from 42% to 30%. (ignoring the Medicare levy of 1.5%) Also, as the IOA interest rate is slightly lower than the variable rate, if she chooses the IOA option she will be required to pay less interest than if she pays next financial year.  Choosing the interest in advance (IOA) option has two additional effects which work against each other to roughly even each other out. 

Money has a time value - a dollar today is worth more than a dollar in one year's time (because it earns interest).  Hence a tax deduction this year is worth more to Susan than a tax deduction next year, as any refund could be reinvested now.  Likewise if Susan pays next year's interest now it will cost her more than the same interest payment in one year's time, as she could have used the cash put towards the interest to invest in some other income producing investment.  In this example the net effect leaves Susan with over $1,000 more in her pocket than if she chooses to remain on her current variable rate loan.

If Susan is contemplating taking some time off from work next year the effect would be amplified.  Let's say she expects her income to drop around 20% next year to about $68,000.  If she chooses the IOA option this year her marginal tax rate will still drop from 42% to 30%.  Due to next year's reduction in tax rates, in 2006-07 her marginal tax rate will fall to 30% regardless of whether or not she pays interest during the year.  In these circumstances, choosing an IOA option will leave Susan with nearly $3,000 extra in her pocket.

Until next month,

Nicholas Gruen
(AKA Dr Peach)

March 2006

The observations made here are general and indicative. They are not warranted as free from error in any respect whatsoever. We are not financial or tax advisers and you should not rely on any aspect of these comments without taking independent financial advice relating to your own specific circumstances. We suggest you obtain advice on a fee for service basis rather than from someone who earns commissions from investments they recommend.

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