Debt Costs
Debt or leverage is an important part of your investment strategy as it allows you to use someone else's money to buy appreciating assets. This is covered in more detail in the leverage section.
In general you should not use debt to fund consumer items or depreciating assets; this is one of the first steps in the roadmap - to pay down consumer debt.
Debt should be thought of as a cost against all your assets, and in particular your lowest returning asset. Paying down debt is the lowest risk investment you can make; if you have any investments planned to return less than your debt interest then you should be paying down the debt first.
Debt costs include interest payments, fees, and charges associated with borrowing money. Comparison rates are required to report the interest rate after fees, but on a $150,000 loan over 25 years. You need to conver that into a comparison rate for your loan size to do a proper comparison.
- Interest Rate Optimization: Lower rates directly reduce borrowing costs
- Fee Minimisation: Eliminating or reducing fees improves overall cost structure
- Debt Structure Optimization: Using offset accounts and flexible features
- Refinancing Strategy: Switching to better terms when beneficial
- Timing Considerations: Taking advantage of market conditions
Debt Cost Minimisation Strategies
Getting the best from the bank
- Shop around for competitive interest rates
- Negotiate with current lender for fee & rate reductions. THe discharge form providers at the bank are generally the people who can give you the largest discounts.
- Consider fixed vs variable rates based on market conditions. When the RBA rate is near zero percent, interest rates can only go up from there, so it's a good time to lock in a fixed rate. In general variable is better off when you're not sure as the rates are generally slightly lower, and if interest rates rise so do you investment return and wage growht.
Offset Accounts
There are cases for offset accounts when a loan is already fully deductible. But for your personal home loan then using a redrawn is generally better due to debt recycling. If you have to pay extra for it, and offset account is not required.
- Reduce interest on home loan by offsetting balance
- Maintain liquidity with access to funds
- Tax-effective for investment property loans
- Flexible access without refinancing
Interest Only loans
Interest only loans are useful in certain situations, but they usually come with a higher interest rate. Generally a Principal and interest as you can refinance it every year to pull the equity out. A few reasons you may consider an interest only loan is that it's an investment loan and you are still paying down your P&I home loan, or you just can't afford the cash repayments due to your situation.
Interest Premium
The interest rate charged by a lender is depending on the risk of the loan not being paid back, and the underlying asset retaining its value. The benchmark used for zero risk is the RBA cash rate, the debt is then a portion above the RBA rate. Home loans are generally around 2% above the RBA rate because people will always pay for their home loan first. While investment loans are slightly more risky for the bank.
Interest Premium by Loan Type
| Loan Type | RBA + | After Tax |
|---|---|---|
| Home Loan - Standard | +2% | 5.5% |
| Home Loan - Debt Recycling | +2% | 2.9% |
| Investment Real Estate | +2.5% | 3.2% |
| Margin Loan | +3.5% | 3.7% |
| Car Loan | +4% | 7.5% |
| Personal Loan | +5% | 8.5% |
| Credit Card | +15% | 18.5% |
You should always pay down the highest interest debt first, and convert high interest into low interest by refinancing to the extent equity can be withdrawn.
FAQ
At least annually, or when rates change significantly. Monitor market conditions and be ready to refinance when beneficial.
Consider total costs including fees and loan features. Sometimes a slightly higher rate with better features or lower fees is better.
When the rate difference exceeds 0.5% and the break-even period is reasonable (typically less than 2 years).
Generally No. There is no difference between an offset account and a redraw facility on a home loan.