Is Principle and Interest (P&I) or Interest Only (IO) better on my investment loan?

Mortgages and interest rates, they are extremely confusing. Here is a recent problem I had, should I go Principle and Interest (P&I) or  Interest Only (IO) on an investment loan. Initially, these seams an obvious choice, go the IO and deposit the saved principle payments into your owner occupied offset, as you are unable to claim the interest at tax time. But this gets a bit more complicated when the P&I interest rate is slightly lower.

Here is how to work it out.

Lets assume your Owner Occupied rate is 4%, IO investment is 5% and P&I investment is 4.8% (0.2% discount). Loan amount is \$500,000, payment over 30 years.

To work out the principle payments each month the Excel formula PMT can be used.

=PMT(4.8%/12, 30*12, 500000)

Which results in monthly payments of \$2,623 or yearly payments of \$31,480. This is the amount that won’t be able to offset the Owner Occupied at 4%, this is equal to \$1,259 a year.

If the P&I and IO rates were the same, we wouldn’t want this loss and stick to the IO, but it isn’t the case. at 4.8% interest first year is \$16,800, whilst IO at 5% is \$17,500, a difference of \$700.

In this case, P&I costs \$559 more a year, and it would be better to go IO, even at a slightly higher rate. Simply, right? Well, not quite.

As investment loans are tax deductible, comparing the interest only isn’t a fair comparison. In a situation where P&I is more cost effective then IO initially, it is worth then calculate the interest payable after factoring the tax deduction. It may make the IO more favourable. But if it does, the savings differences may be negligible compared to other factors.

How to calculate comparison interest rate in Excel

Searching for how comparison interest rates are calculated, I found an article on Tomorrow Finance, but unfortunately a lot of the numbers provided no insight into how they were calculated. I hope to break it down further and explain how to calculate comparison interest rates with Excel. The Excel formula can be quite tricky and the parameters vague, so I will go through each of the formula as well.

• rate – the interest rate of the loan annually equal to 4.63% (the current rate most banks are offering as of today)
• principle – the loan amount always equal to \$150,000 when calculating a comparison rate.
• period – the period in years always equal to 25 years when calculating a comparison rate.

Payments for a loan

Firstly, calculate the monthly payments for a loan based on constant principle payments and a constant interest rate. The key here is to convert the interest rate to a monthly interest rate and the number of periods also in months.

`payment = PMT(rate/12, period*12, principle)`

In this case payments equals -\$844.86 per month and includes principle and interest. The figure is negative since it is an outgoing.

Total interest payment

`total payment = payment * 12 * period`

Since the monthly payments are all the same, the total payments is simply the monthly payment multiplied by 12 months by 25 years, this equals -\$253,456.66.

`total interest = total payment + principle`

The total interest is imply the total payment (which is negative) plus the principle, this results in a total interest only of -\$103,456.66.

A quicker way to calculate the cumulative interest over the lifetime of a loan is;

`total interest = CUMIPMT(rate/12, period*12, principle, 1, period*12, 0)`

Next the additional fees over the lifetime of the loan are added, usually these are annual service fees, with nab there is a -\$395 annual service fees. The total fee over the life of the loan would be 25 years multiplied by -\$395 which equals -\$9,875.

`total outgoings = total interest + total fees`

The total outgoings over the life of the loan would be the total interest and total fees, this would equal -\$113,331.66.

`outgoings = total outgoings / 25 /12`

To get the outgoings per month divide by 300 to get -\$877.77 per month.

Comparison rate

Finally, the comparison rate can be calculated;

comparison rate = RATE(period * 12, outgoings, principle)*12

The rate is per month which is multiplied by 12 to get an annual comparison rate, in this case equal to 0.050101482 or 5.01%.

Calculate last business day in month with Excel

Here is a quick post to calculate the last business day in a month taking into account holidays.

This is useful for with finance calculations and wanting to know a bank’s last banking day in a month.

`=WORKDAY(EOMONTH(A2,0)+1,-1,holidays!A:A)`

Where;

• Cell A2 is the reference month cell
• Range holidays!A:A is a list of holidays

Home loans – Fixed vs. Variable interest rates

I saw an interesting chart on Canstar which plotted the history of RBA Cash Rate, variable and 3-year fixed interest rates. This data is all available on the Reserve Bank of Australia website, look for A2 and F2 statistics.

I thought I would take it a step further and determine from past history if the 3-year fixed or variable rate would have been a better choice at a given time. I always believe that choosing a 3-year fixed interest rate was like gambling, it could either work in your favour or not, I am curious to see if I am right.

Given monthly data for the variable interest rate, to calculate which would have been the better choice I average thirty-six months of future variable rates. Because it is constantly looking three-years into the future, it can be observed that the data finishes in February 2010.

What can be observed is that the fixed rate is sometimes a better option (when under the three-years future average) and sometimes it is worse. Pre 2000, the fixed was mostly a poor choice, post 2000 the fixed rate is lower most of the time.

Finally, a difference of the two and it can be seen that it really jumps back and forth between good and bad. If we take the average of the difference we get 0.41%, which means the 3-year fixed rate is generally an interest rate of 0.41% worse.

Out of 233 months, 121 months (or 52% of the time) the fixed had a worse off interest rate and 112 months (or 48% of the time) the fixed had a better interest rate.

However, if we look at the 121 months from 2000 onwards, the variable interest rate is better off by an average interest rate of 0.23% which occurs about two-thirds of the time.

In conclusion, 3-year fixed rates these days do seem to have a good chance of having a lower interest rate for the locked-in period. That combined with the advantage of having a non fluctuating interest rate makes it a good choice.
I still would avoid them though, fixed rates make it difficult to switch lenders due to the extra fees payable.

To trust or not to trust – the benefits of a discretionary (family) trust – final comparison

I have discussed the benefits of a discretionary trust aka family trust for minimising capital gains tax (CGT). I have also discussed the benefits of a discretionary trust from minimising taxable income. For this last part I am going to compare a discretionary trust against a direct 50-50 split over an average person’s lifespan.

Again similar to the previous examples a 50-50 split is exactly that, two persons owning half a property each, any income is split equally. Also as per previous examples, one person will be earning a secondary external income of \$100,000. As before, I have assumed a \$1,000 annual fee for trust management.

The following examples try to emulate a real world situation, the purchase of a property, initially purchased under a mortgage with some rent, initially the property will be negative geared. I have assumed all income after tax goes into paying the mortgage, this would never be the case in the real world, so the examples below show the property being paid off much quicker than normal. Finally, once the properties has been paid off savings are accumulated which includes interest. This interest in the same as the mortgage interest, which wouldn’t be the case as it would always be slightly lower.

As previously discussed a 50-50 split is always more beneficial compared to a discretionary trust when the properties are negatively geared, so to make things interesting I have added cases were they begin with a 50-50 split, then once the property is positively geared it changes to a discretionary trust.

The following scenarios are used for the situations;

• 50-50 – a split of the property when each person owns an even 50%
• Trust 2pers – a discretionary trust with 2 beneficiaries
• Combo – starting with a 50-50 split and then moving to a trust with 2 beneficiaries once the property is positively geared
• Trust 3pers – a discretionary trust with 3 beneficiaries
• Combo2 – starting with a 50-50 split and then moving to a trust with 3 beneficiaries once the property is positively geared

Example 1 – mortgage \$500,000, rental yield 2.5% and interest 7%

First a 30 year chart of the yearly income after tax

The first abnormality that can be observed on the combo situations is a bump in income at around the 5 year mark, this is the point where the property goes from negatively geared to positively geared, and as I stated above, this is when the combo situations move from a 50-50 split to a trust. But why the bump/ well, because you have changed the title from two persons to a trust, stamp duty is payable, for a \$500,000 property roughly \$18,000 is payable. Stamp duty is what makes it unappealing to move to and from a trust situation, it is the believed reason key decisions about the trusts need to be made early on, as it is expensive to change your decision later on.

Looking at the cumulative wealth over 30 years, this provides a clearer picture

Straight away, at 30 years the order of scenarios providing the best return in descending order are the second combo, the three person trust, the 50-50 split, the first combo and lastly the two person trust. The difference between the best and worst results is \$280,000 which is very significant for a 30 year projection. The difference at around 10 years is only \$20,000, since the trusts are playing catch-up from the period of negatively gearing. If you look closely it can be observed the two combo scenarios have a very slight dip around that fifth year corresponding to the stamp duty.

Example 2 – mortgage \$1,000,000, rental yield 2.5% and interest 7%

Again, a 30 year chart of the yearly income after tax

A couple of things to notice, first the bump at the 13 year mark signals where the property moved from negative geared to positive geared, a larger mortgage means longer time to pay off. A higher valued property also means more stamp duty for \$1,000,000 the stamp duty is around \$43,000.

Looking at the cumulative wealth over 30 years

Firstly, the order of scenarios after a 30 year projection has changed, the 50-50 split and combos are in the lead, whilst the two trust scenarios are trailing.  The difference between the best and worst results is \$250,000 which is very significant for a 30 year projection.  We can see the affects of the stamp duty a lot more clearly on the light blue and green lines and the trusts only scenarios never recover from the start.

But what if the cumulative wealth is projected over 50 years

The trust scenarios are back in the lead. Because of the larger time negatively geared and larger stamp duty, the trust scenarios needed more time to ‘catch up’.

Example 3 – mortgage \$250,000, rental yield 2.5% and interest 7%

As above, a 30 year chart of the yearly income after tax

As expected, there is a very short period of negative gearing, roughly 3 years. Due to the relatively low value property, the stamp duty is also minor at \$7,000.

Looking at the cumulative wealth over 30 years

As expected, due to the short negatively geared period, the trusts are beneficial for the majority of the projection period.

Conclusion

So what does this all mean?

Making the correct decision about trusts can save you hundreds of thousands of dollars in the long run. In general if a property is positively geared it would benefit if it is in a trust and if a property is negatively geared it would benefit if owned individually.

The good news is, if planning to hold for the long term it, it can be decided to move to a discretionary trust scenario, as the benefits will eventually out way the costs. When the property is positively geared move it to a trusts, but be prepared to hold it to offset the stamp duty.

To trust or not to trust – the benefits of a discretionary (family) trust for minimising income tax

A few weeks ago I blogged about the insignificant benefits of a discretionary (or family) trust compared with a basic 50-50 joint split when it came to Capital Gains Tax (CGT), this week I will compare the two when it comes to rental income.

Rental income is different to CGT in that rental income is generally a lot less, and secondly, it is an annual income so any tax benefits can be compounded yearly. The results should be the same for values when Capital Gain and Rental Income are he same.

Again, I have based the below charts on a 50-50 split were one person has an supplementary income of \$100,000 per year. I have ranged the annual rental income from minus \$250,000 to plus \$250,000, this is a huge sum for rental income and would require around \$5000 rental income per week, and this is all after management costs and deductions.

A basic comparison between the two, with annual rental income versus total tax payable, it can be observed that that at values less than -\$163,500 (a significant yearly loss), the 50-50 split can use negative gearing to offset the individual \$100,000 supplementary income, whilst the discretionary trust cannot take advantage of negative gearing. This means there will always be a \$25,000 tax bill as long as the properties are negatively geared.  As the net rental income approaches zero (or neutrally geared), the 50-50 split tax and trust tax merge.

Finally, once the property is positively geared, the benefits of a discretionary trust are visible; the first \$18,200 is tax free and following from there the tax bill is always slightly lower than the 50-50 split.

Plotting the tax difference between the two, a positive value being when a discretionary trust is beneficial, it can be observed that the maximum difference is around \$3,300 with incomes around \$18,000 to \$36,000, this is a significant yearly saving.

Looking at the percentage difference compared to the yearly income, it can be again observed that at \$18,000 or income a maximum of around 18% can be saved when a discretionary trust is used. It dips and stops at around a yearly income of\$70,000 were it then hovers around 1% percentage difference.

So what does this all mean?

Firstly, a discretionary trust should not be used for negatively geared properties, this is obvious.

Secondly, a discretionary trust has significant benefits when used for positively geared properties. And because this in annual income, these benefits are compounded yearly. A saving of \$3,300 yearly is a saving of \$33,000 over ten years.

So one would think it would be wise to move the properties into a discretionary trust as soon as the properties are positively geared.

I will investigate this in my next post.

Update September 2012

Something I failed to mention was that whilst a trust is not beneficial for negative gearing, losses stay in the trust, meaning when the income is positively geared, tax will be minimised while the losses are accounted for.

To trust or not to trust – the benefits of a discretionary (family) trust for minimising CGT

Discretionary or family trust is a trust where the income generated in the trust can be distributed to the beneficiaries at the discretion of the trustee, or simply the income can be divided up however one pleases.

It is commonly known that a discretionary trust can be used as a form of tax minimisation, but to what extent is a trust beneficial.

In this example I will look at a simple case, a married couple with an investment property that has had a capital gains tax trigger. One person works with a salary of \$100,000 a year while the other doesn’t. Logical sense would suggest that a trust would be beneficial in this situation since the capital gain can be distributed to the person with the lowest income, the person not working.

For the below charts I have calculated the tax of a 50-50 split and the tax of a discretionary trust from a capital gain from zero to \$1,000,000 incremented by \$10,000. One of the persons has a salary of \$100,000.

First a direct comparison, it can be observed that up to around \$400,000 that the 50-50 split pays slightly more tax, after \$400,000 the tax is exactly the same. The reasons for this is the upper limit of the maximum tax threshold for an individual is \$180,000, for two people it is \$360,000, therefore when this is reached, it doesn’t matter whether it is a direct 50-50 split or a discretionary trust, the capital gains tax will be exactly the same.

Zoomed in to the zero to \$400,000 range, it looks like there are some definite benefits to a discretionary trust.

Let’s look at the difference between the two scenarios in tax paid, a positive value is how much a discretionary trust minimises tax compared to a 50-50 split. It can be observed that a maximum of \$4000 is saved when the capital gain is \$260,000, not much of a saving. Further, as per above, at capital gain greater than \$360,000 there is no difference.

Now one of the problems with a discretionary trust is the yearly management and compliance costs, let’s assume this is \$1,000. Let’s add this to the differences chart. As expected this shifts everything down by \$1,000.

And what this does is makes a trust scenario a bad choice for any capital gains greater than \$360,000.

So what does this mean, simply, in the above situation a discretionary trust does not provide any significant benefits for capital gains tax minimisation compared to a 50-50 split.

One also needs to take into consideration the cumulative costs associated with a trust. If a property is held in a trust for four years, this is \$4,000 of cumulative yearly costs which negates any benefits of a discretionary trust.

Further, if both parties are not working, there will be a disadvantage with a discretionary trust due to the yearly costs.

A discretionary trust may be beneficial for positively geared investment properties, and I will discuss this later on. But when asked the question, should I purchase an investment property into a discretionary trust to minimise future capital gains tax, it makes no difference as the CGT is relatively the same.

I will also add, what about a married couple with children, surely I can distribute the capital gains within my family, yes you can, but minors (children under the age of eighteen) are taxed at the highest tax bracket, so it is beneficial only when the beneficiaries are adults.

Next I will investigate the benefits of a discretionary trust for minimising annual income tax.

Triplex Development – Contour Survey

One of the first things you should arrange prior to designing the buildings on the block is a contour survey of the land, a contour survey provides information on the elevation of the land and also situations of sewerage, water and power connections as well as positions of existing fences and trees.

Generally, a builder will arrange for a contour survey prior to providing a building design, I found the most benefit of arranging the contour survey myself was the home builders took me more serious, after all a contour survey is a one-thousand dollar investment.

I arranged my contour survey with Cottage Engineering, a Perth based surveyor company. It cost me \$975 which also included \$180 for Australian Height Datum (AHD). AHD is an elevation standard which assumes a zero metre elevation is at the average mean sea level. One of the builders informed me it wasn’t really necessary and only needed if the land is situated near the ocean.

Cottage Engineering even provided the AutoSketch SKF file, which was handy for the builders.

Contour Survey for Cloverdale PDF