Chapter 02 – Forms of finance

There are several common forms of finance used to fund business and investment activities.

Term loans

Term loans are the next most common form of finance. Most clients will have them. Term loans are simply a loan for an agreed period or term. They can be interest-only or principal and interest and they can have a fixed or variable interest rate.

Term loans can be repaid early without penalty if the interest rate is variable. If the interest rate is fixed, the bank loses if the loan is paid out early and this loss is almost always passed on to the customer.

Beware of changing banks just because one is offering an interest rate that is one percentage point below the others. Ask how long this will last and whether the discount continues if the loan is reviewed. The answer is usually no.

Term loans can be used to create flexible debt packages that achieve personalized financial goals. A client who owes $400,000 on a loan used to buy a property could structure the debt by having $300,000 as fixed interest-only for five years and $100,000 variable interest and principal for five years.

This combination means that the client can be reasonably certain of the net cost of the finance for five years, as three-quarters of the interest charge is fixed, and ensure a significant amount of debt ($100,000) on the variable interest loan will be paid off within five years. Some principal can be repaid early without penalty. At the end of the fifth year the remaining debt of $300,000 would be refinanced with the same bank or a new bank in line with the market conditions and the client’s circumstances at the time.

Principal and interest term loan

A principal and interest (P&I) loan is a term loan where the borrower agrees to make regular repayments of principal in addition to paying regular instalments of interest. For example, suppose an investor borrows $100,000 with an annual interest rate of 6%. This gives rise to an annual interest charge of $6,000. The lender might then require the investor to repay an amount of $750 per month. Over the year, this will amount to $9,000. Assuming there are no other costs, this means that the investor has (a) paid the $6,000 interest and (b) repaid $3,000 of the amount borrowed. At the end of the year, the investor only owes the bank $97,000. The amount borrowed is known as the ‘principal’. Because each repayment includes an amount of principal as well as the interest for the period, the loan is known as a principal and interest loan.

In a P&I loan, the amount of the monthly repayment is typically fixed and only changes if interest rates change. Therefore, over time, the proportion of each repayment that is principal and the proportion that is interest change. This is because the amount of the principal is falling and the interest payable is the interest rate times the amount of principal outstanding. Over time, this means that the proportion of the repayment that represents principal increases. Consider the following example of a loan for $100,000 with a 6% interest rate. The borrower will repay $13,320 per year (we refer to annual repayments to keep the example workable. In reality, this would be divided into 12 monthly repayments of $1,110).

Year Annual payment Interest component Principal component Principal still owing
0       $100,000
1 $13,320 $6,000 $7,320 $92,680
2 $13,320 $5,560 $7,760 $84,920
3 $13,320 $5,095 $8,225 $76,695
4 $13,320 $4,602 $8,718 $67,977
5 $13,320 $4,079 $9,241 $58,736
6 $13,320 $3,524 $9,796 $48,940
7 $13,320 $2,937 $10,383 $38,577
8 $13,320 $2,314 $11,006 $27,571
9 $13,320 $1,654 $11,666 $15,905
10 $13,320 $954 $12,365 $3,539
11 $3,751 $212 $3,539  –

Ignoring the small payment in the 11th year, we can see how a comparison between the first year repayment and the 10th year repayment shows that the principal component rose from $7,320 in the first year to $12,365 in the 10th year. Accordingly, the proportion of interest is higher earlier in the loan period and falls as the principal is repaid.

Interest-Only Loans

As the name suggests, an interest-only loan is one in which the periodic payments made by the borrower to the lender include only the interest that has accrued on the loan. To give a simple example: if a borrower borrows $100,000 at 6% per year, and is obliged to make one repayment a year (this is an illustrative example), then the amount paid to the lender will be $6,000.

Interest-only loans contrast to principal and interest loans, in which the periodic payments include an amount of repayment of the initial amount borrowed. With an interest-only loan, at the end of the loan period, the amount borrowed is the same as it was at the commencement of the loan period. The borrower has simply serviced the loan. 

Interest-only loans are often used when the amount borrowed is used to purchase investment assets. By making these ‘investment loans’ interest-only, the borrower avoids having to use cash flow to make loan repayments on debt that is giving rise to tax-deductible interest. Accordingly, ignoring changes in interest rates, the amount of tax-deductible interest does not reduce over time.

By not repaying the principal amount of the investment debt, the borrower ‘frees-up’ cash flow to be used for some other purpose. This may include the repayment of other loans which were not taken out for investment purposes, such as a private home loan. Because the interest on the private debt is not tax deductible, private debt is effectively more expensive than investment debt. So, by preferring to repay the expensive debt, the borrower reduces the effective amount of interest paid overall.   

Interest-only loans are also used where borrowers expect the capital value of the purchased asset to increase over time. To give a very simple example: suppose a borrower borrows $100,000 as an interest-only loan and uses it to buy units in a managed fund. The loan term is five years. After five years, the managed funds have increased in value to $130,000. The borrower sells $100,000 of the units in the managed fund, uses it to repay the debt and is left with an asset valued at $30,000.

Of course, there is a danger that the asset will not rise in value – but this is a risk of all investment borrowing and is not specific to interest-only loans. Indeed, where interest-only loans reduce the amount of after-tax interest being paid on all of the borrower’s loans, they can actually serve to reduce the overall risk to the borrower. The total cost of the debt is reduced, meaning that the amount by which assets need to increase in value so as to justify the decision to borrow to invest is lessened. 

Interest-only loans are also sometimes used by borrowers who use the debt for private purposes, such as a home loan. This is usually done to maximise cash flow. For example, a family in the high cost years of raising children might change their home loan to interest-only so as to ‘free-up’ as much cash as possible for daily living expenses.

Another common presentation is where a borrower makes their loans interest only, and uses the money that would otherwise have been dedicated to repaying principal to finance extra superannuation contributions. The plan is usually for the superannuation contributions to be withdrawn later in life and used to repay the loan. This can make sense because the superannuation contribution is only taxed at 15%, whereas the income may be taxed at a higher rate in the borrower’s personal hands. So, for every $1 of pre-tax earnings, the borrower can repay more debt if the $1 passes through their superannuation fund rather than their own hands. This strategy is discussed in greater detail here.

ASIC tells us that 2 out of every 3 investment loans is interest-only, while 25% of owner-occupied loans are interest-only. You can read more about interest-only loans on the ASIC website here.

Overdraft

The bank overdraft is a simple concept. It is like a bank account, but instead of you being owed money by the bank, you owe money to the bank. The amount that you owe fluctuates over time as funds pass in and out of the account. Interest is almost always fully tax-deductible even when a private or non-business cheque is written. The revolving nature of the overdraft means the Commissioner of Taxation is not able to trace through the overdraft account to apportion interest between deductible and non-deductible purposes.

Bank overdrafts tend to be at a high rate of interest. At the moment, 8% or more is common. You also have to factor various bank charges into the cost of the finance. These can easily add another 1% or more to the cost of the overdraft.

Overdrafts have the advantage of being flexible so you only pay for the money you use for the time you use it. Normally banks require a first mortgage over real estate to secure amounts lent on overdraft facilities. The better the security, the lower the interest rate.

Bank overdrafts are a sensible way of funding most small-to-medium businesses.

Finance leases

Under a finance lease, the lessee borrows an amount of money equal to the cost of the asset being leased. The lessor owns the asset but the lessee is able to use the asset provided that the lease payments are made on a regular basis and particularly with larger leases, the asset is properly housed maintained and insured.

Finance leases are normally used for plant and equipment, and furniture and fittings purchases, as well as motor vehicles.

The advantage of a finance lease is that all payments made under the lease agreement are tax- deductible, even though part of the payments is a repayment of part of the principal amount borrowed to buy the asset.

The taxation advantages of leases can be overstated. Most items of plant and equipment can now be depreciated over either a three or five-year period. In the case of a four-year lease of computer equipment, the cost of the equipment would have been depreciated over three years anyway, so a lease would be tax-inefficient.

Most lease contracts provide for a residual payment at the end of the lease term. If this residual payment is not made, possession of the leased asset will revert to the lessor. In most cases, the lessee will make residual payments but you should not make a residual payment if for any reason the market value of the leased asset falls below its residual value.

The ATO has released guidelines for the minimum term and residual payments for leases. These guidelines must be satisfied before the ATO will accept that the finance contract is a lease and the lease rentals are deductible losses and outgoings for income tax purposes.

For example, if you buy a computer using lease finance over three years, the Australian Tax Office will only accept that the lease rentals are deductible if the residual value is not less than 30% of the amount of the cost of the computer.

Normally leases do not require any additional security because the leased asset provides sufficient security. However, financiers normally will not enter into lease contracts with companies without directors’ guarantees. Larger contracts or contracts for unusual and hard-to- sell plant and equipment may require collateral security.

The luxury car depreciation rules do not apply to lease contracts. This makes leases particularly attractive for buying cars with a cost of more than about $60,000 (more for environmentally friendly cars such as cars with diesel engines). All lease rentals, including those connected to the cost above the luxury car limit, will be deductible.

Commercial hire purchase

Commercial hire purchase contracts are similar to lease contracts. They are typically used to buy plant and equipment, and furniture and fittings, including cars.

The big difference is that the borrower borrows money to buy the asset and is the owner from day one. This means the borrower is able to depreciate the asset for income tax purposes. The payments made under the hire purchase contract are a mix of principal and interest, and the amount of deductible interest will calculated using the ‘rule of 78’, a method that calculates how much interest has been earned at any stage during repayment of a fixed-interest loan.

The principal component of the payment is not be tax-deductible.

Commercial hire purchase will be more attractive than a lease where the borrower has some equity in the asset being financed. The cost of the asset will be depreciable under a hire purchase contract, including the owner’s contribution, even though only part of this amount is financed using debt. However, under an equivalent lease contract the lessee’s contribution will not be depreciable because the lessee will technically not own the asset. Only an owner can claim a deduction for depreciation.

Mortgage originators

These firms provide a real alternative to traditional bank finance. Companies such as Aussie Home Loans and RAMS now account for a significant share of housing finance in Australia.

Clients who have dealt with these companies report well on them. They seem to provide a good service and are able to provide lower-cost finance because they do not support the infrastructure of the larger banks. They just organise loans and are not the principal lender. The principal lenders are the larger merchant banks that are attracted by the security and low administration costs of this type of finance.

Interest charge checkers

A number of firms have entered the personal and small business financial market as interest charge checkers. Often staffed by retired bank managers, they use precise interest rate calculations to identify interest charge errors and bank charge errors. Small amounts add up, particularly if there is a pattern of overcharging. The firms collect the refunds for you.

Clients should use these services if they believe they have been overcharged on interest or bank charges. There are also some good software packages available that do the checking for you.

Lines of credit

A line of credit is a loan where an upper limit is set and, provided that the investor maintains a loan balance below this limit, they can move money into or out of the account as they see fit. Interest is only payable on the actual amount of money drawn on the account at a given point in time. The loan is typically secured against an asset such as property.

A line of credit may be best understood using an example. John Smith owns a home worth $500,000. He offers the home to his bank as security for a line of credit with a limit of $200,000. The interest rate is 6%. The loan takes effect on 1 January. On that day, John draws $50,000 and buys shares in various companies. He holds the shares for the whole month. At the end of the month, he has to pay interest to the bank. The interest is calculated as follows: ($50,000 @ 6% per year) divided by 12 = $250. John pays this to the bank, and the value outstanding remains $50,000. On 1 February, John sells $25,000 worth of shares and deposits the proceeds back into his line of credit account. The outstanding balance is now only $25,000. At the end of the month, he again has to pay interest to the bank. The interest is calculated as follows: ($25,000 @ 6% per year) divided by 12 = $125. John pays this to the bank and the value outstanding remains $25,000.

As the example shows, provided that John does not go over his limit, the loan remains in place. In most cases, the interest for each month can be added to the amount previously drawn. That is, on 31 January, John could have chosen to add $250 to the $50,000 drawn, leaving him with a total debt of $50,250 as of that date.

There is an obvious risk inherent in a line of credit: this kind of loan requires discipline on the part of the borrower, because the lender typically leaves the investor alone unless the upper limit of the loan is reached. There are no minimum monthly repayments and, therefore, the borrower can find that the debt accumulates more quickly than they anticipate.

Margin loans

A margin loan is a loan secured against a financial instrument such as shares or units in a managed fund. Lenders typically lend investors an amount equal to 65-70% of the value of the portfolio being held or acquired. That is, the LVR is typically 65-70%.

The name ‘margin loan’ comes from the fact that the lender wants to keep the value of the debt within the prescribed margin (i.e. between 0% of the value of the portfolio and the nominated LVR). The value of the financial instruments on which the loan is provided are often quite volatile in the short term. This means that the value of the portfolio may also be subject to rapid change. Where the value of the portfolio falls to the extent that the level of debt exceeds the prescribed margin, the lender will require the borrower to do one of three things:

  1. repay some of the loan
  2. provide further assets as security; or
  3. sell some of their holding and use the proceeds to repay some of the debt.

When the lender does any of these things, it is known as a ‘margin call’. Most lenders allow a little leeway in the value of the financial instruments before making a margin call. This leeway is known as a ‘buffer’. Some lenders allow a buffer of 5% over the prescribed margin of (say) 70%. This buffer is designed to reduce the need to take action when a financial instrument temporarily dips in price and the prescribed margin is exceeded.

Interest rates on margin loans are typically higher than for home loans. This reflects the fact that there is generally a greater risk that the financial instruments used as security will fall in price. This increases the risk that the lender will not be able to retrieve the loan amount. The lender increases the interest rate to compensate for this increased risk.

Margin loans can operate in one or both of the following ways:

  1. as a line of credit; and/or
  2. as a means of increasing an amount being invested.

To use a margin loan as a line of credit, a borrower needs to own some financial assets. They offer the lender security over these assets and, in return, the lender makes some loan monies available to them. The borrower is free to use these loan monies in any way they like; this may or may not mean that the loan is used to finance further investment.

To use a margin loan as a means of increasing the amount being invested, the borrower deposits some of their own money into the margin loan account. The lender adds some loan money and makes a purchase of financial instruments on behalf of the borrower. The lender retains a mortgage over these assets.

Many investors use margin loans in this second way to facilitate a dollar cost averaging strategy. If a borrower contributes $500 to the account each month and the lender also contributes $500, then the borrower is investing $1,000 each month. Meaning, the starting margin will be 50%.

The most obvious risk in a margin loan is that the value of the asset(s) that are used as security will fall such that a margin call ensues. To manage this risk, prudent investors keep the starting margin (i.e. the margin at the time the loan money is borrowed) well below the prescribed limit. If a lender has a limit of 70%, then a borrower may choose to borrow only 50% of the value of the portfolio. This means that the price of the assets can fall substantially before the prescribed margin is reached.

Margin loans were popular with clients up to the GFC. But harsh margin calls and high interest rates between 2008 and 2011 caused a lot of pain. Memories linger and in 2014 margin loans are not popular with clients.

The Dover Group