Hi All
I am trying to work out which is worth more. A $ earned or a $ saved. By this I mean if you put a $ in a high interest account and earn interest on that is that worth more than say paying a $ on a loan which stops interest long term?While you maybe saving money, your not actually making more money, then there is the tax on the money you earn in interest.
Does it depend on the rates of interest and the ammounts of the loan ?
Let take the below for example. $150 000 loan and $30 000 in a high interest account. 6% interest on the loan and 5% interest on the high interest account.Some one please set me straight
Thanks in advanced
GI imagine it would also depend on your income and so your applicable marginal tax rate… I don't know exactly the tax scales off by heart but they are easy enough for you to look up on the ATO website, but if you are in a 30 cents in the dollar marginal tax bracket then if you earn 5% of $30000 = $1500 – 30% tax = $1050… Obviously if you are in a higher marginal tax bracket of say around 40 cents in the dollar = $900 after tax that you would make from it… that's just for the basic interest for the total amount of the year, not sure if it was interest credited each quarter and so compounded a bit etc… no expert on these high interest accounts…. but it adds up to, on the 40% tax bracket (return of $900), an effective interest rate of 3%….
i imagine on the loan you should be saving the equivalent of 6% each year on each dollar that you are not paying the interest on tax free… and over the life of the loan i would have to think that would add up to more than the effective 3% high interest savings account…
but others might be able to give you a more definitive answer…
It really depends on the loan
Is the loan a massively negatively geared investment loan
so when you pay off more on the loan you decrease the loss and then get less of a tax deduction. However you usually only get 30% of your loss back.
So $150,000 * .06 = $9000 interest expenses
pay of $30,000
SO $120,000 * .06 = $7200 in interest expenses
$9000 * .30 = 2700 tax return opposed to $7200 * .30 = 2160 tax return so you have lost $540 in tax deduction but saved $1800 in interest expenses.
This $1800 saved actually would come off your loan amount if repayments were kept the same
So next year you would have a loan of say $116,000 before interest reduction and $114,200 with the reduction
$116,000 I pulled this out of thin air as I do not know how much you are normally paying off loan in a year.
now $114,200 * .06 = $6852 the following year in interest charges. You get a compounding effect from reducing the loan while keeping the repayment the same. This over 10 years can save you a lot of interest.Lets take the $30,000 and put it in a bank
Year one $30,000 * .05 = $1500 – Taxed at 30% = $450 = $1050 minus 2% for CPI = 600 equals $450 in real terms
Year two $31,050 * .05 = $1552 – taxed at 30% = $465.50=$1086.40
year three $32136 * 0.05 = $1606 taxed at 30% = $482.40 = $1123.60
After ten years this will grow to $40886 and tax at $613 p/a
However $30,000 is no longer worth $30,000 after ten years . It doesn't buy the same as it did ten years ago due to inflation.
Based on a 2% CPI you have really only made $4317 as $36569 is what buys $30,000 in ten years time due to inflation.
However the tax man doesn't use indexation on savings interest earned so it really is probably about 3% a year in interest you are earning even though tax is on the 5% interest.Back to the loan while you have been saving money off the loan the property would have been going up in value over the ten years.
Say loan was $300,000 and you paid of an extra $30,000 interest before $30,000 equals $111,774
after total interest is $96,389 you save $15,000 in interest over twenty years due to compound effect.you could use an offset facility to get more flexibility.
It's generally better to pay off non-deductible debt like a PPoR loan, which stops interest long term – it's a guaranteed return of whatever % interest rate you are paying on the loan. Money in high interest account general has poor after-tax, inflation-adjusted returns.
E.g, mortgage inerest is 7%p.a. versus deposit rate of 5%p.a. (which is about 2-3% in real terms).
So paying off the loan is generally better.
Cheers
Paul.factor tax in too.
Terryw | Structuring Lawyers Pty Ltd / Loan Structuring Pty Ltd
http://www.Structuring.com.au
Email MeLawyer, Mortgage Broker and Tax Advisor (Sydney based but advising Aust wide) http://www.Structuring.com.au
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