Non-deductible debt is expensive debt.

Non-deductible debt should always be paid off as a priority over any other investment.

If your client earns more than $180,000 a year they face an effective marginal tax rate of 47%, made up of 45% and plus a 2% Medicare Levy (2.5% from 1 July 2019).

This means your client has must earn virtually $2.00 for every $1.00 of interest paid.

If the annual interest cost is $10,000, your client has to earn $18,868 of pre-tax income (net of super), calculated as $10,000/(1 – 47%), and the effective pre-tax equivalent interest rate is 9.4%, calculated as 5%/(1 – 47%).

The position for the lesser tax rates is tabulated here:

Income Effective marginal tax rate Factor Amount of interest Pre-tax equivalent income Nominal Interest rate Effective pre-tax interest rate
$18,200 19% 0.81 $10,000

$12,345.67

5% 6.1%
$37,000 34.5% 0.655 $10,000 $15,267.17 5% 7.6%
$87,000 39% 0.61

$10,000

$16,393.44 5% 8.2%
$180,000 47% 0.53 $10,000 $18,867.92 5% 9.4%

What is non-deductible debt?

Non-deductible debt is debt that is not connected to income, and is private or domestic in nature. Examples include bank loans to buy homes or to pay for renovations, and consumer credit card debt.

What should you advise your client to do?

You should always advise your client to use their cash reserves to pay off non-deductible debt before they make any other investment.

And if your client wants to acquire an investment they should:

  1. use their cash reserves to pay off the non-deductible loan and then
  2. borrow to acquire the investment

in effect replacing expensive non-deductible debt with cheaper deductible debt.

No other investment compares with paying off the home loan. It is risk free, in that there is no risk of capital being lost, and the effective pre-tax interest rate of up to 9.4% (assuming home loan rates of 5%) beats everything. The Russell ASX Long Term Investment Report tells us that Australian property averaged 10.5% and Australian shares averaged 8.5% in the 20 years to 31 December 2015. But both property and shares have a risk of capital being lost.

Paying off a non-deductible debt is risk free.

Which non-deductible debt should be paid off first?

The most expensive non-deductible debt should be paid off first. This will usually be your client’s credit card debt, which can be up to 18% non-deductible, and therefore a whopping 33.96% effective pre-tax interest rate.

What if interest rates rise again?

The completely persuasive inarguable case for paying off non-deductible debt becomes even more compelling if interest rates rise.

For example, if home loan interest rates increase to 10% a year a high tax rate client will face an effective pre-tax interest rate of nearly 20% a year.

The position is as follows:

Income Effective marginal tax rate Factor Amount of interest Pre-tax equivalent income Nominal Interest rate Effective pre-tax interest rate
$18,200 19% 0.81 $20,000 $24,691.34 10% 12.2%
$37,000 34.5% 0.655 $20,000 $30,534.34 10% 15.2%
$87,000 39% 0.61 $20,000 $32,786.88 10% 16.4%
$180,000 47% 0.53 $20,000 $37,735.85 10% 18.87%

What about interest offset accounts?

Interest offset accounts are strongly encouraged. These accounts allow clients to in effect earn the home loan interest rate on their savings, tax free, rather than the much lower and taxable deposit rate, and retain full accessibility.

For example, a client with a 5% non-deductible home loan of $100,000 and a 1.5% bank account of $20,000 should transfer the $20,000 to an interest offset account. If they do are in effect swapping a taxable 1.5% for a non-taxable 5% on their $20,000.

That is, at an effective marginal tax rate of 47%, they are going from an after-tax earnings rate of 0.795% – ie 1.5% x (1 – 47%) – to an effective pre-tax interest rate of 9.4%.

What about interest offset accounts on investment loans?

Interest offset accounts on investment loans are useful, but should only be used once all non-deductible debt has been re-paid.

If a client has an interest offset account on an investment loan and a non-deductible debt the client should withdraw the monies and either pay off the non-deductible debt or deposit the monies into an interest offset account linked to the non-deductible debt.