Financial planning is really about… educating clients about debt (2)

People with deductible debt are borrowing whenever they invest. This includes if they make increased super contributions.

A client with debt faces a choice as to what they do with their income. Option 1 is to use the income to retire some of their debt. Option 2 is to spend the money elsewhere. Only one option can be taken. This means that any decision to take option 2 has the effect of leaving the debt higher than it would be if option 1 had been taken. This means that, effectively, any money spent on option 2 is borrowed money.

This can be a key thing to remember when clients have deductible debt. When these clients spend money on any other things, they have effectively borrowed, in a manner such that the interest is deductible, to do so.

For this reason, there is often less urgency in retiring deductible debt than there is to retire non-deductible debt. 

This concept can be especially useful to keep in mind when a client is using after-tax employment income to retire debt. If that client instead salary sacrifices an equivalent pre-tax amount (which will be grossed up) into super, then they have effectively borrowed a tax-deductible amount to make a super contribution.

Here is how it works. A client has an investment loan worth $100,000. This loan gives rise to interest of $5,000 a year. The client is currently paying $1,000 a month in principal and interest repayments. That’s $12,000 for the year. The debt will reduce by $7,000 this year. 

The applicable tax rate is 30%. In order to repay the $7,000 of principal, the client needs therefore to earn $10,000 before tax. If the client changes the loan to an interest only loan, then they can instead arrange to salary sacrifice an extra $10,000 into superannuation without affecting their day-to-day purchasing power. In the super fund, the tax rate is only 15%, meaning that there is $8,500 left within the fund after tax.

So, while the investment loan is still $100,000 – and thereby $7,000 more than it would otherwise have been – there is now an additional $8,500 worth of assets in the super fund. Essentially, the client has borrowed an extra $7,000 to buy super fund assets worth $8,500. This is an immediate $1,500 increase in the client’s net assets. $1,500 is 21.4% of $7,000. So this investment has achieved an immediate return of 21.4%. 

Please take care to ensure that the borrowed money flows correctly. We are talking here about not repaying money that has already been drawn on the loan. Interest on a loan is only deductible if the money actually drawn on the loan is used for some legitimate purpose. The client cannot claim a tax deduction for interest on money that is drawn and used for a private purpose. For example, occasionally a client will think that a loan secured against an investment property gives rise to deductible debt even if the money drawn is used for some private purpose. This is not the case. The security for the loan does not matter; the use to which the loan money is put is what matters. 

Adviser tip – here is how you might suggest it

Can you see these paragraphs in your next client communication:

At present, all of your debt gives rise to interest that is deductible. We recommend that you do not make any efforts to retire this debt. Instead, cash that you might use for this purpose should instead be used to build your asset base, which has the same effect on your net asset levels. (You might suggest specific things like facilitating increased deductible super contributions, purchasing investment assets, or even paying school fees, etc).

The Dover Group