Financial planning is really about… managing non-deductible debt

Non-deductible debt is expensive debt.

A client with a non-deductible debt is an opportunity for you to pick some low hanging fruit in terms of making that client wealthier.

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 need to 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:

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:

  1.  your client’s marginal tax rates increases, is as they earn more (bear “bracket drift in mind); and/or
  2.  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:

Tax rate Gross-up factor Interest rate Pre-tax equivalent interest 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 tabulated here:

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.

The Dover Group