Non-deductible debt management

[ October 16, 2015 ]

We would like to see more SOAs helping clients manage their non-deductible, therefore very expensive, debt.

A client with a non-deductible debt is an opportunity for you to kick an easy goal and pick a low hanging fruit.

Most clients, other than retirees or soon-to-be-retirees, have some form of non-deductible debt, typically a home loan or a credit card loan. The interest on these debts is not deductible because it is not connected to assessable income and is essentially private and domestic in nature.

If you can reduce your client’s non-deductible interest by $1,000 a year your client will save more than $14,000 cash over the next ten years. That’s a huge saving. You cannot ignore this potential saving if you want to be sure you are always acting in your client’s best interests and providing advice that is appropriate to your client.

You can easily improve the quality of your SOAs by making sure every client meeting considers this important issue and you do everything you can to make sure your client’s manage their non-deductible debt as best they can.

Your client gets a great return on your investment. The extra twenty minutes you spend explaining debt management principles and drafting a few extra explanatory paragraphs in your SOA may save your client a small fortune over the next few decades.

Little suggestions now may lead to big gains in your client’s net wealth over time, and big improvements in the strength of your relationship with your client.

If you want to be your client’s trusted adviser you better know how to help them with their non-deductible debt problems.

How much does non-deductible debt cost?

Non-deductible debt costs a lot. Most clients have to earn a lot more than $1 to pay $1 in non-deductible interest. The position for an average home loan costing 5% per annum is tabulated here:

Client’s tax rate Gross-up factor Interest rate Pre-tax equivalent interest rate
19% 1.23 5% 6.15%
32.5% 1.48 5% 7.4%
37% 1.58 5% 7.9%
47% 1.88 5% 9.4%

This means clients earning more than $37,000 a year faces an effective pre-tax equivalent interest rate of 7.4% on their home loans. It also means that the client earns an effective pre-tax equivalent interest rate of 7.4% by paying off their home loan. And paying off a home is tantamount to a risk free investment. So that’s 7.4% capital guaranteed, ie risk free.

Obviously the equivalent pre-tax equivalent interest rate increases as:

  • your client’s marginal tax rates increases, is as they earn more (bear “bracket drift in mind); and/or
  • interest rates increase, and given rates at currently at historic lows it is reasonable to assume that they will increase in the future.

What about credit card debts?

The position is worse for credit card debts and other non-secured personal debt, because obviously the interest rate is a lot higher. The average credit card debt interest rate is about 17% per annum. So the position looks like this:

Client’s tax rate Gross-up factor Interest rate Pre-tax equivalentinterest rate
19% 1.23 17% 20%
32.5% 1.48 17% 25%
37% 1.58 17% 27%
47% 1.88 17% 32%

That’s ridiculously expensive money.

What is the equivalent pre-tax cost of non-deductible interest?

Looking at the same phenomena another way, we can tabulate how much extra pre-tax income a client needs to earn to pay say $1,000 of non-deductible interest. The position is shown here:

Client’s tax rate Gross-up factor Amount of interest paid Pre-tax equivalent cost
19% 1.23 $1,000 $1,230
32.5% 1.48 $1,000 $1,480
37% 1.58 $1,000 $1,580
47% 1.88 $1,000 $1,880

This means if a client in the top tax rate reduces their non-deductible interest costs by $1,000, it is the same as earning an extra $1,800 a year.

Common client presentations and suggested paragraphs for your SOA

Opportunities are endless and arise every time a client presents with a non-deductible debt, such as a home loan or a credit card.

Obviously your advice will depend on the client’s specific circumstances.

The purple paragraphs are sample suggested paragraphs to be included in your SOAs where appropriate to your client.

Suggested SOA paragraphs for every client with a home loan

A Big Bang: let’s make something from nothing

You have a home loan of $300,000 and you are paying 5% interest, or $15,000 a year. This is expensive money: you have to earn $23,700 a year to fund this loan because the 5% after tax interest rate is the same as a 7.9% pre-tax interest rate.

It makes sense to pay your home loan off as fast as possible. This is step number one in creating your long-term financial plan.

We will prepare a cash budget for you to identify how you can increase your cash receipts, and decrease your cash payments without unduly affecting your preferred lifestyle. The net cash saved should be used to pay off your home loan as fast as possible.

I aim to identify cash savings of about $4,000 a year, which if used to repay your home loan faster will generate significant long term savings, ie more than $67,000 over the next twenty five years, and create a sound base for your long term financial plan.




Suggested SOA paragraphs for a client who should consolidate a credit card debt on to a home loan and use the cash saved to fund a salary sacrifice strategy

Turn your credit card debt into an extra $140,000 of super

I suggest you ask your bank manager to increase your home loan by an amount equal to your credit card debts, and that you use this to pay off your credit cards. Consolidating your debts into the lower cost home loan will save you about $2,000 cash a year, and this is the same as earning an extra $3,000 of salary.

I recommend that you do not spend the extra $2,000 cash a year, and that you instead ask your employer to reduce your salary by $3,000 and pay an extra $3,000 to your super fund.

This simple strategy, compounded over the next twenty-five years, will add more than $150,000 to your retirement at age 65 (subject to some assumptions about future earning rates). The position is charted here:

(Assumptions: 9% return; 15% tax)


Suggested SOA paragraphs for a client who should change their home loan repayment frequency from monthly to fortnightly at a reduced amount.

Simple change, big consequences!


Suggested SOA paragraphs for a client who should consolidate a credit card debt on to a home loan and use the cash saved to pay extra home loan principal repayments

I suggest you ask your bank manager to increase your home loan by an amount equal to your credit card debts, and that you use this to pay off your credit cards. Consolidating your debts into the lower cost home loan will save you about $2,000 cash a year and this is the same as earning an extra $3,000 of salary.

I recommend that you do not spend the extra cash and that you instead increase your home loan payments by $2,000 a year. Doing this will save you a total of $40,000 interest over the next twenty five years, and reduce term of your home loan by about 4 years. This is shown here:

(Assumption: 5% interest rate, 25 year loan term)


Suggested SOA paragraphs for a client who should negotiate a lower home loan interest rate

For completeness, I note that your home loan rate looks a bit high. You appear to be paying 5.2%m but we have similar clients with the NAB only paying 4.8%. We suggest you e-mail your bank manager asking for a lower rate. A sample e-mail from you (ie the client) to your bank manager may include these paragraphs:

My financial planner has advised that my home loan interest rate is more than other clients are paying. I am paying 5.2% but others are paying only 4.8%.

Could you please reduce my home loan rate to 4.8%, or alternatively explain to me why my rate is higher?

Suggested SOA paragraphs for a client with a rental property loan and a home loan: debt recycling strategies

You are implementing classic residential property negative gearing strategies while they still have home loans. This creates a financial planning opportunities based on maximising your deductible debt, and thereby minimising your overall after tax interest rate.

One strategy is based on borrowing to pay outgoings connected to the investment property, such as rates and repairs, and using the extra net rent cash flow to pay off your non-deductible home loan faster than otherwise.

Another strategy is based on making sure your investment loan is interest only, and no principal is re-paid, and that any spare cash from any source is used to pay your home loan off as fast as possible.

Both these strategies are specific examples of a general strategy commonly known as “debt recycling”. You can read the AMP’s technical materials on “debt-recycling” here:AMP materials on debt recycling.

Suggested SOA paragraphs for a client with a home loan and who is approaching retirement age

At age 55 you are now approaching retirement and should consider not paying any principal off your home loan and instead using your cash to fund pre-tax salary sacrifice super contributions.

For example, rather than paying $10,000 off your home loan, you should instead ask your employer to reduce your salary by $15,873 (which is the same as $10,000 after tax at your 37% tax rate), and pay the $15,873 to your super fund.

At age 65 you can withdraw the $15,873 (less the 15% tax of $2,380) and use the net amount of $13,493 to pay off your home loan.

You are in effect using super as a tax benefitted home loan reduction device.

Let’s look at some of the common mistakes or omissions involving non-deductible debt

Exploring some of the common big mistakes adviser make regarding debt management helps explain how you can get better results for your client.

Some debt management mistakes we have seen over the last year include:

  1. an adviser suggested an insurance bond based savings plan to fund school fees while the client had a large non-deductible home loan. Insurance bond net income is taxed at 30% in the insurer’s hands, and there is no CGT discount, so an insurance bond is never going to beat paying off the client’s home loan, which has a capital guaranteed effective pre-tax earning rate of about 9% pa. The best way to pay the new baby’s school fees is to pay off the home loan as fast as possible;
  1. a similar SOA discussed what to do with a $50,000 cash windfall. It suggested a managed fund. The problem was the client had a home loan of more than $50,000. So the corrected SOA said “pay the $50,000 on to your home loan, and then borrow $50,000 to invest in the managed fund”;
  1. failing to recommend $40,000 in a cash deposit be paid on to a large non-deductible home loan (via the interest offset account). When it was noted to the adviser he said “but that is outside the scope of the advice”. That’s like a doctor not bothering to mention the cancerous growth on your nose because you consulted her about your in-grown toenail. We suggested two simple paragraphs, as follows:

I know its outside the scope of my advice, and you did not consult me specifically on this issue, but for completeness I suggest you transfer the $40,000 in your cash account on to your home loan (via your interest offset account so you can get it back easily if you need to).

This will save you about $2,000 a year in non-deductible interest. In your 40% tax bracket this is the same as earning about $3,500 in pre-tax income, and only costs you $400 in foregone interest income. In other words, this is the same as increasing your salary by about $3,100 a year, every year.

The feedback was positive. The client loved the advice and happily accepted the adviser’s other recommendations including the risk insurance recommendations. It really helped get the relationship going;

  1. failing to recommend a large credit card debt (ie about $15,000) copping a whopping 18% interest a year be consolidated into the client’s home loan which enjoyed a low 4.7% interest rate. Doing this saved the client $1,995 a year [ie $15,000 times (18% less 4.7%)] which at a 40% tax rate is equivalent to earning $3,325 a year in pre-tax income [ie $1995 divided by (1 – 40%)]; and
  1. similarly, failing to suggest the client re-negotiate a $500,000 NAB home loan at 5.2% when the adviser knew other clients in similar circumstances were paying only 4.8%. The difference of 0.4% is significant. $500,000 times 0.4% is $2,000. And at a 40% tax rate the client has to earn an extra $3,333 in pre-tax salary to get an extra $2,000 in after tax cash.

The client sent an e-mail that read like this:

I notice that a colleague in similar circumstances is paying 4.8% per annum interest on her loan, while I am paying 5.2% interest on mine.

Could you please reduce my rate to the same as hers? Or, if this is not possible, explain why I am paying a higher rate than her?

The bank manager dropped his interest rate to 4.8% without further ado.

So, suggesting the client e-mail his NAB bank manager asking for same interest rate as the NAB’s other customers (which took less than ten minutes) was the same as earning a $3,333 pa salary increase.

This will compound to more than $20,000 cash over the next ten years.

Interest offset accounts

Interest offset accounts (IOAs) are useful devices. In summary, an IOA reduces the client’s non-deductible debt, and thereby reduces the client’s non-deductible interest, say 5%, which for a 45% taxpayer is the same as earning about 9% before tax.

You can read the ANZ Bank’s IOA information here: ANZ IOA Information.

But IOAs are more than this. We habitually recommend clients keep their old home as a rental property when they up-grade to a bigger and better home (or down-size to a smaller and lower maintenance home). With returns on Australian property averaging 9.8% in the 20 years to 31 December 2015 (source: Russell ASX Long Term Investment Report) this has proven to be an excellent strategy over team.

Obviously the IOA allows clients to legitimately minimise their non-deductible debt by allowing them to, in effect, withdraw their equity from their old home and take it with them to their new home. Minimising non-deductible interest and maximising deductible interest is a key part of any debt management strategy.

Reverse mortgages

Finally, reverse mortgages should be considered where appropriate for the client. A recent client advice may help explain how reverse mortgages can be used to help clients.

The client was suffering from frugality. She could not even afford to get hair done, something which hurt. She had always taken pride in her appearance, and now she could not afford to do so. She lived on her own in Hampton, an up-market suburb between Sandringham and Brighton, in suburban Melbourne. It was the old family home and it was all she had. She was not leaving. Too many memories.

The adviser’s draft SOA only dealt with pension entitlements. The final SOA included paragraphs on:

  • getting a lodger in, for company and cost sharing; and
  • implementing a small scale reverse mortgage strategy to free up $500 cash a week without impacting the old age pension.

The client loved the advice, and is getting her hair done one a week again.

You can read Dover’s views on reverse mortgages here: Dover’s views on reverse mortgages. And you can read ASIC’s views on reverse mortgages here: ASIC’s view on reverse mortgages.

As you can see, used carefully, they can be great. They can be very appropriate to your client and very much in your client’s best interests.

AMP materials on managing debt

The website contains useful materials on debt management,.

Linking these materials into your SOA saves you time and trouble: why re-invent a good wheel? The AMP check every syllable on their website before they publish it, so using these materials adds extra authority and gravitas to what you say.

Topic Link to the AMP Personal Insights
What is equity and how can I use it to invest in property? AMP materials on investing in property
The benefits and risks of using the equity in my home for investing? AMP materials on using your home as equity for investing
The difference between good debt and bad debt AMP materials on the difference between good debt and bad debt
Gearing and investing in property AMP materials on gearing into property
What is debt recycling? AMP materials on debt recycling
How can the equity in my home fund my retirement? (Includes reverse mortgages) AMP materials on reverse mortgages

We recommend you support and verify your case to your client by using these materials and similar materials, with appropriate credits.

The Dover Group