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The ideal loan structure for someone who has paid off the main residence

Discussion in 'Property Finance' started by Terry_w, 29th May, 2016.

  1. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    The ideal loan structure for someone who has paid off the main residence


    I have written a thread on my idea of the ideal loan structure here Terryw’s Ideal Loan Structure


    Where someone has already paid off their main residence the ideal loan will be very similar to the one I have described in the thread above. But there are slight differences so here is another ‘ideal’ structure.


    Should the loan be PI or IO?

    Normally you would have an IO loan on an investment property. One of the main reasons would be so you can divert extra funds to the non-deductible PPOR loan. In this case, there is no non-deductible debt so this is not such an issue.


    However going IO may be better still for a number of reasons such as:

    - You may want to upgrade the main residence at some point and need cash

    - You can still pay the loan as PI and revert to IO if or when you want

    - You will still save the same amount of interest

    - You could retire earlier and use the offset to live on and this would be more tax effective


    But paying PI may be beneficial where:

    - The lender differentiates on rate

    - Serviceability is an issue

    - You are tempted to spend large sums of cash


    Ownership Structure should also be considered

    A simple example is buying one property in the name of spouse A and another in the name of spouse B. Money can then be moved between offsets as circumstances change so as to get the best tax position.


    Deposits

    You might save up enough cash in an offset (on one IP) to be able to pay a 20% deposit on the next property. Taking the cash out of the offset would have the same tax effect as setting up an LOC on an existing property and borrowing the deposit. But there are longer term aspects to consider.

    Having large sums of cash in offset accounts would be better for retirement. You could use the money to pay for private expenses and the interest on the loans would increase and this interest would be deductible. So indirectly you are borrowing to fund private expenses and the interest will be deductible.


    This can allow retirement to be brought forward compared to using cash as deposits.


    In summary, my ideal structure is:

    PPOR paid off

    LOC secured against the PPOR

    LOC split into relevant portions


    LOC portion A used for IP 1 deposit and stamp duty etc.

    80% of IP purchase borrowed from a lender (ideally separate lender to the LOC) and be IO. Offset account attached to this.

    One owner of this property.


    LOC portion B is used for IP 2 deposit and stamp duty etc

    80% of IP 2 purchase borrowed from another lender.

    If this property is owned by the same person as IP 1 there is no need for an offset account. If owned by the other spouse an offset may be needed.


    LOC Portion 1 should be converted to a term IO loan once the IP1 has settled – because the rate will generally be lower and you will get a term loan instead of a loan at call. It will also help for servicing.


    Once IP 1 grows in value the amount used the LOC portion A should be borrowed by increasing the IO loan


    Example with figures

    Frank has a $500,000 PPOR fully paid off.

    He sets up a $400,000 IO loan with Westpac – which can be used just like an LOC. (Loan 1)


    He then goes out and finds a nice IP (IP1) for sale for $500,000.

    He goes to ANZ and borrows $400,000 (Loan 2), IO with an offset

    And uses $140,000 from Loan 1.


    Once IP 1 settles he arranges for the Westpac loan to be split as follows:

    Loan 1a $140,000

    Loan 1b $260,000 (unused)

    No need to convert the LOC into an IO loan because it already is one. But if he went to another bank he would have converted it.


    Mrs. Frank decides to buy a property now, IP2 for $500,000

    Mrs uses $140,000 deposit from Westpac’s Loan 1b.

    $400,000 is borrowed from CBA as an IO loan with an offset.


    Frank had saved up $100,000 in the offset against Loan 2, but Mrs Frank has a lower taxable income than Frank so he transfers the $100,000 into her offset. This results in more income being generated from her property (as there are fewer costs due to the lower interest incurred). Mrs pays less tax on the income than Frank would.


    By this time, Frank’s property has jumped in value to $700,000. 80% of the value is $560,000 so Frank increases his loan with ANZ from $400,000 to $540,000 and he uses the extra $140,000 to pay off the Westpac loan 1b. This loan can now be used for the next IP deposit. It also brings all the debt associated with the IP1 property into one loan which makes it more administratively convenient.


    They may buy a few more properties along the way using the same structure as above.


    After a while, they may now have, say, $500,000 saved up in the offset account against the two properties. They want to buy a new property for $500,000. They could just pay cash. But if they decided to borrow 105% as above.


    They now realise their income from rent is approx. 70% of what they need to reach their goal of giving up work. Instead of working another 5 years, they decide to stop work early. They live on rents and use their offset cash to pay for the rest of their living costs knowing that every time they buy groceries the interest on their investments increases and so does their tax deductions. This lessens the cost of retirement. Every 12 months their rents increase and their offset account doesn’t drop much at all. They can keep it there was a buffer while living on the rents and have a passive income which grows faster than inflation (hopefully) as well as the capital base also growing faster than inflation.


    Each year they move the cash in the offset around so that they end up with taxable income the same as each other as this will result in the least tax being payable.