This situation commonly plays out where someone buys a property, often their first property, and thinks they’re doing all the right things by trying to pay down their mortgage as quickly as they can. You make extra repayments to get your debt down, and over a period of time you make some real progress.
Then, as time passes you realise you want to upgrade your home for more space, a different location, or some sort of combination of the two.
If this happens to you, you’re probably going to be in a strong position to borrow more money from the bank.
Because you’ve paid down debt, your savings capacity and debt servicing capacity are higher, and more than likely your first property has increased in value, which gives you some more ‘equity’ to borrow against.
To buy your new property you need a deposit, and because you’ve paid down a heap of your debt you have the ability to simply ‘redraw’ money from your mortgage.
This gives you the deposit for your new property, and once you have that deposit the banks will typically lend you the rest of the money to fund your purchase.
The redraw mistake
But the issue with this approach comes from the different tax treatment of redrawing money.
In this example, because the purpose of redrawing money from your mortgage is to buy your own home, under the tax rules the interest on this debt isn’t tax deductible.
So in this case, your new property is entirely funded with non-tax deductible debt.
And it gets worse if you intend to keep your original property, which many people want to do because either they have an emotional attachment to the property, because they think it will keep growing into the future, or simply because the cost of buying and selling property is so high.
For your first property, this will now be converted to an investment property.
This gives you the huge benefit that as soon as this happens, all of your mortgage interest costs immediately become tax deductible.
This sounds great, but there’s one big problem - because you have paid down a chunk of the mortgage debt on this property, your interest costs, and therefore your tax deductions, are a lot lower.
Zooming out to the big picture in this scenario. You have high non-tax deductible debt on your home, and low tax deductible debt on your investment property. There is a better way.
Offset accounts are different
If you take the same situation, where you buy your first property and then want to upgrade a few years later, if you take a slightly different approach with the same inputs, you can get to a much better position.
Say for example your aim is to reduce your debt by $250,000 of debt over a number of years.
If you pay this money directly into your mortgage through extra mortgage repayments, you will end up in the position I’ve outlined above.
But if you instead direct the money to an offset account, you change the game.
When you put money into a mortgage offset account, it has the exact same impact in terms of reducing your interest costs.
But the important difference is that putting money in an offset account doesn’t technically reduce your mortgage debt.
This may sound like a bad thing, but when it comes time to upgrade your property it gives you a huge advantage.
If you then withdraw the $250,000 from your mortgage offset account to use as the deposit for your new property, because the debt on your original property mortgage was never technically paid down, it means that the debt on this property will be higher.
And because this debt is tax deductible, this means more tax deductions for you.
At the same time, you are effectively using $250,000 in cash as your deposit for your new home, meaning the non-tax deductible mortgage on your new property will be $250,000 lower in this scenario.
The impact on your bottom line is significant. $250,000 of deductible mortgage debt at the current average interest rate of 6.5 per cent will deliver you $16,250 of tax deductions every year moving forward.
If your income is above $45,000, these deductions will score you an extra tax refund of $5,200 based on your marginal tax rate + medicare levy of 32 per cent.
And if your income and tax rate is higher, the benefits will be even higher.
And the best part of this is that you have exactly the same level of debt, you have the exact same properties, and the ongoing cost of servicing your mortgages will be exactly the same.
The difference is an extra $5k+ every year dropping into your bank account, all just from using the existing rules a little smarter and to your advantage.
The wrap
The rules around borrowing and debt can be confusing and complicated if you don’t know how they work, but the reality is that building your knowledge will be seriously valuable.
When you take the time to understand how to optimise what you’re doing today, you can get more out of the money you already have. The juice really is worth the squeeze.
Ben Nash is a finance expert commentator, podcaster, financial adviser and founder of Pivot Wealth. Ben’s new book, Virgin Millionaire; the step-by-step guide to your first million and beyond is out now.
If you want to review your existing mortgage and see how much money you can save, you can use our free mortgage comparison tool here.
Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.
