Interest only with an offset against PPOR

Thought I'd share this post on the new forum - again, it's commonly asked so hopefully some of the newer members will benefit.

A common question that I'm asked and which frequently comes up on the forum is whether a borrower should opt for principal and interest or interest only repayments against their Principle Place of Residency (PPOR).

For that reason - I thought I'd provide a rundown on the topic.

I see it every day. Clients who pay down a large portion of the loan on their PPOR and are now looking to upgrade to another house while keeping their current property as an Investment Property (IP).

So what's wrong with this? In short, when their current property turns into an IP, the loan against this property is generally quite small (as they've paid down a considerable amount of the principal) - which means they can only claim a small amount of interest. The good news is that there's a way around this - but it's important that it's set up correctly from the start.

Let's look at an example.

The not so ideal situation
Jim purchased his first home in 2009. It was a nice little 1 bedroom apartment in the centre of town. He took out a loan of $300k for it.

The loan was set-up as principal and interest and Jim was determined to pay off his loan as quickly as possible.

It's now 2015 and Jim has managed to get his loan down to $100k.

Jim has now decided he would like to buy a larger house but keep his little one bedroom apartment as an investment.

Because Jim has paid his loan down to $100k - when this property becomes an IP, he can only claim interest on a $100k loan (which is about $5k per annum on 5% interest rates) which isn't ideal since the property is now worth about $500k and is going to get $500 per week rent.

To make matter worse, Jim wanted to use the equity in his first property to purchase his next one. The issue is that the equity he is accessing from his 1 bedroom apartment won't be deductible because it's being used to purchase a PPOR.

So in this scenario, Jim has reduced his tax deductible (IP) debt whilst increasing his non-deductible (PPOR) debt. Not ideal!

So how do we get around this?

The ideal situation
If Jim had set up the loan as Interest Only (IO) with an offset from the beginning; he could have eliminated this issue.

Instead of paying down the principal, Jim could pop all of his spare money (including the would be principle repayments) into the offset account which provides a similar outcome to paying down the principal. Instead of having paid down his loan to $100k, Jim would have $200k sitting in his offset account and only paying interest on the remaining $100k.

When it comes time to convert this property into an IP, Jim can simply take the funds out of his offset account, which will boost the loan back up to $300k, and use those funds towards his next PPOR. This way, Jim has basically increased his deductible debt (IP loan) back to its original level of $300k whilst reducing his non-deductible debt (PPOR loan) by $200k.

Now Jim is able to claim interest on a $300k loan (which is closer to $15k per annum on 5% interest rates).

Please note - this structure (interest only with an offset) works well for those disciplined with money who will make an effort to regularly contribute to their offset account and not just make the minimum interest repayments. For those that are not disciplined with money - principal and interest may be a better option.

Not all banks are keen on interest only against a PPOR either - so it's important that you use a lender conducive to your requirements.

All in all - make sure that you plan ahead! Not doing so could wind up costing you thousands.

Hope that helps someone

Cheers

Jamie

This information is of a general nature. Please always consult taxation professionals about the specific nature of your situation.

 

Great article Jamie, explains my thoughts exactly, I'll change my PPoR to interest only soon, don't know why i set it up differently, oh well better late then never.

I borrowed more then needed for my PPoR to enable me to increase the amount in offset 67% LVR, not sure if I should of borrowed even more, but ah well hindsight is great isn't it..

 

You remind me of SS forum
Great post, Jamie

 

As I would like to upgrade PPOR in next five or so years I will be doing interest only.

 

Isn't the present way the banks are measuring serviceability a problem ??

ie : - They assess the IO loan as if it is P&I for the remaining term and apply margins etc ?

 

Hi Jamie,

Thanks for sharing this. Also to add, I think some banks allow for multiple offset bank accounts for the one loan. (I have multiple offset accounts setup with CBA) and that helps with budgeting and keeps funds separated so one doesn't spend it if they are not disciplined..

 

Yep - spot on, some allow for multiple accounts which some borrowers love.

Personally - I like less as best. I just have the one offset.

Cheers

Jamie

 

It's a problem for some borrowers.

Some banks are still calculating OFI debt at actual - so a PPOR loan set up as IO could help. Others such as the Nab group apply a 28% loading to OFI debt which also helps in this situation.

If you've got a PPOR debt set up as IO - and use a lenders that takes OFI debt at the remaining P&I term and an inflated assessment rate, it will reduce your borrowing capacity a bit. Not sure if it would be enough to justify setting up a PPOR loan as P&I if borrower believes it could turn into an IP at some point.

Too many acronyms - time to get a coffee.

Cheers

Jamie

 

It's a problem for servicing, but this doesn't change if your loan is P&I. Either way it gets assessed as P&I.

As Jamie said, b/c some lenders still take actuals IO is beneficial in those cases, and neutral when dealing with lenders that assess at P&I. It doesn't take away the benefit of using an IO loan on your PPOR.

 

In the interests of providing a balanced point of view, I'm reposting some of the old Somersoft comments regarding the I/O vs P&I debate. Please don't misinterpret this as disagreeing with anything Jamie has stated, he's spot on and the arguments are well constructed. I do think it's necessary however that people understand that the simple "I/O for everything" isn't always the best solution.

It's important to recognise what your plans are and to understand what that translates to in terms of appropriate loan structuring. There is no single solution that fits everyone. Certainly if your home has the potential to become an IP in the future then I/O loans are likely to be the way to go. On the other hand I've met home owners who never intend to invest, have taken I/O loans and will still owe the same amount of money on the day they retire.

 

What's OFI again?

 

Other Financial Institutions.

Cheers

Jamie

 

Thanks, so many acronyms.

 

Tell me about it.

Probably should start a sticky thread with all the acronyms - I think there was one on SS.....sorry, I mean somersoft.

Cheers

Jamie

 

For the long term, the quick you pay off your loan, the less you pay for the interest, right?

Otherwise, the loan still is your debt. Unless the market goes up, then you may not worry too much for the debt.

If the market goes down, it will be a huge trouble.

 

Placing money into a linked offset will result in the same outcome.

Cheers

Jamie

 

You will actually be better off potentially. if the market goes down so could your income. This may mean you won't have enough cash flow to meet repayments, especially if PI. if you lost your job you would come to this situation quicker. But if you had built up a large sum in an offset account you could use this to pay the loan for much longer before you run out of cash.

 

oh, I see.

 

Hi Jamie,

Thanks for your tips. Before finding Somersoft, I bought my first PPOR 3 years ago and signed up for P&I 80% LVR with redraw with HSBC. I have placed excess funds into the loan and redrawn money for an investment properties and other debts and purchases. I plan to upgrade and convert this property to an investment property. What options do I have to increase my deductions? I do plan to buy more investment properties in the future so could I refinance or draw the equity to fund my future investment properties to maximise the deductions? Thank you. Sean

 

You have little to no options in increasing the deductible loan for this property. What you should do is to work out the portions of the loan relating to the various borrowings and then split the loan asap, converting it to an IO loan at the same time. This way you can stop paying it down, which would cause you to lose deductions in the future (and now on the investment parts) and it will also allow you to set up an offset on the non deductible portion to save you interest.