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Debt Management

Reducing debt is considered a low risk strategy. You can save money in interest payments without the risk of market volatility.

 

Benefits

  • You can reduce the overall interest cost on your loan.
  • You may be able to reduce the term of your loan.
  • You have potential to increase your wealth by directing surplus cash flow towards savings instead of repaying non-deductible debt.

 

Options for managing debt

The following strategies may be able to help you reduce your debts faster, relieve your cash flow, reduce your overall interest cost and reduce the term of your loan.

 

Make additional repayments

A simple strategy to reduce your debt is to make additional repayments with your extra cash flow or savings. Not only will this reduce the level of your debt, but it will also reduce the overall interest you pay over the life of your loan.

 

A similar strategy is to make your repayments more frequently. Interest on your loan balance is calculated daily, so the more frequently you make repayments, the quicker your debt will fall. One idea is to halve the amount of your monthly repayments and repay this amount fortnightly instead. As there are 26 fortnights in a year compared to 12 months, this adds an extra couple of repayments to your loan each year.

 

Use an offset account or redraw facility

Offset accounts and redraw facilities both allow you to put money against your loan to reduce the amount of interest you pay, whilst also enabling you to withdraw the money if you need.

 

  • Offset account – allows you to put money into a bank account which is attached to your loan
  • Redraw facility – allows you to put extra money straight onto your loan.

 

To improve the effectiveness of these features, you could use a credit card with an interest free period to pay for your everyday expenses, thereby allowing your cash to sit longer in your offset account or redraw facility. However this strategy will only be effective if you ensure the full balance of your credit card is repaid in full every month.

 

Consolidate your debts

Debt consolidation is where several loans are combined into one loan account. An example would be to increase your home loan to repay your car loan and credit card debts.

 

Debt consolidation can help to:

  • ease cash flow – annual repayments on the one loan might be less than your total repayments on the separate loans
  • reduce fees – you will only pay account fees and transaction fees on one loan account
  • improve manageability – you will only have one monthly statement and one monthly repayment.

 

Potential disadvantages of debt consolidation include:

 

  • longer repayment period – a loan which might have been paid over a shorter period may be extended unless your total repayment levels are maintained
  • increased interest cost – if your loan term increases, the total interest cost over that term may also increase
  • fees – a loan restructure may incur additional fees and charges.

 

It is important to be disciplined when consolidating debt to ensure that debt is not re-accumulated from other sources. It is particularly important to take care with the use of credit cards – ensure the full balance is repaid every month and/or reduce the credit limit.

 

Repay high interest rate debt first

If you hold a number of different types of loans, such as a home mortgage, a personal loan and a credit card, the interest rate applying to each loan will usually be different, with some rates being considerably higher than others. Repaying the loans with the higher rate first will create savings compared with repaying all the loans at the same time.

 

For example, a credit card will usually charge the highest rate of interest, so by directing extra savings to repay this debt instead of the home mortgage (which usually has a lower rate of interest), you can save interest over the long term. If implementing this strategy, it is important to continue making the minimum required repayments on other loans at the same time.

 

Repay non-deductible debt first

A loan that is used to purchase an asset that does not generate income is called a non-deductible debt. These loans include your home loan, personal loans and credit cards. Your interest repayments on these loans are not generally tax deductible.

 

Loans to purchase assets that produce taxable income for you are called deductible debts. They include margin loans, investment property loans and investment loans to purchase shares and managed funds. Your interest repayments on these loans are generally tax deductible.

 

The tax deduction associated with deductible debt helps to reduce your cost of borrowing. The value of deduction is dependent on your marginal tax rate – the higher your marginal tax rate, the higher the value of your deduction.

 

Example (deductible debt): Tom borrows $100,000 to buy a share portfolio. His interest only loan has an interest rate of 7% per annum and Tom pays tax at the rate of 34.5% (including Medicare). The interest payable each year is $7,000 ($100,000 x 7%). Tom claims this amount as a tax deduction which reduces his income tax otherwise payable by $2,415 ($7,000 x 34.5%). This means Tom has indirectly reduced the interest cost of his loan to $4,585.

 

As non-deductible debts do not contain any tax benefit to help reduce the cost of your loan, these loans should be repaid as quickly as possible.

 

Other things you should know

  • All borrowing requires discipline. It is important not to over-commit as this will increase the likelihood that ongoing interest and loan repayments can be met.
  • Before making any changes to your loan, you should confirm with your lender what fees and charges may apply if your loan is restructured or if you make additional repayments.
  • You should review your life insurance cover regularly as your debt levels change. It is important you have sufficient cover to help meet loan repayments in the event that your income ceases because of illness, disablement or death.
  • Tax advice should be sought prior to making any changes to investment related borrowings.

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