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Prepaying Interest – Why would you?

Prepaying Interest – Why would you?

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Are you looking for tax deductions for this financial year? You may be considering prepaying interest on your investment loan. Investors often use this strategy, with the sole purpose of maximising tax deductions on investment properties. However, you may wonder if giving all that money to the bank the right thing to do…

The upside:

  • Tax strategy

    For the financial year (FY) in which you prepay interest, you can have a double deduction of the interest paid on your investment loan. This is because you would have been making the monthly interest repayments throughout the year. You then make another lump sum payment just before 30th June (i.e. end of FY). You can now claim double deductions in that year, as the lump sum payment has prepaid the following financial year’s interest. This is a beneficial tax strategy, if during the financial year your income is abnormally high and you have a lump sum sitting in your bank account.

  • Lower interest rate

    Usually, you will get a discount on the standard interest rate. When you choose to prepay interest, the banks usually discount between 0.1% and 0.2% off the 1 year fixed rate. However, in the current market, interest in arrears products (i.e. variable or 2 & 3 year fixed rates) have lower interest rates than the interest in advance products.

  • Set & forget strategy

    The money is paid and locked away. You won’t need to worry about ensuring there are sufficient funds in the account for monthly direct debit or changing interest rates.

The downside:

  • Returning to interest in arrears at the end of the prepaid term

    You have prepaid interest for the current FY and claimed it in the previous FY. Therefore, when you revert back to not prepaying interest, in that FY you will have no deductible interest (minimising deductions). This means that once you select to prepay interest, you will have to continue that way until a year in which your income is significantly lower to revert back to interest in arrears.

  • Lump sum funds required

    You will need to have sufficient funds available to prepay the interest.

  • Availability of funds

    Obviously, once the lump sum payment is made, that money is no longer available to you.

  • Changing market conditions

    You may get caught in changing market conditions and not be able to take advantage of competitive interest rates on offer. Typically, interest in advance does provide a slightly discounted interest rate. However, currently the 2 & 3 years fixed rates are lower still. For example, if you are on a 1-year interest in advance payment plan and it is coming to an end (as we are nearing 30 June), you might be thinking about taking advantage of other lower rates available. This means you will have to go back to interest in arrears. The result being, for the current financial year you will not have an interest deduction component (as the prepaid interest was claimed in the previous financial year).

So, what should you do?

Whether or not this strategy will benefit you, depends very much on your personal circumstances. Good advice is the key. Talk to us today, on (08) 9289 7777, Finance Detective can help you find the answer.