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Sunday, 17 June 2007

When You Don't Need to Pay Off Debt

Mighty Bargain Hunter recently posted about paying off Mortgage debt sooner rather than later. The point being that a mortgage is like any other debt and in the early days of a loan the interest cost eats up a huge amount of each repayment, so making some extra payments can have a huge impact in getting the loan paid off sooner.

However, while it is true that most people want to pay off their home loan as soon as possible, or at least before they retire (so they don't have to fund loan repayments out of their retirement income), it's not true of all mortgages. In particular many people will borrow to invest in a rental property, and, at least in Australia, most of the long term benefit of this type of investment is expected to come from eventual capital gains, rather than the rental income. For example, rent yield is taxable income, but at around 3%-4% of the value of the property, it will be less than the tax deduction provided by the interest on the property loan (say 8%). This means that you will be losing money on the investment property on a cash flow basis, at around 4% of the property value each year (this is known as "negative gearing"). But this interest is tax deductible, so 30%, 40% or more of this amount is effectively being paid from money you'd otherwise lose to income taxes anyhow. The payoff comes (hopefully) when the property is eventually sold for a capital gain. As the Capital Gains Tax rate for assets held over 12 months is half the normal marginal income tax rate the total return on the investment property (rent plus capital gains) can be slightly less than the interest cost and you will still end up ahead due to the tax savings. Many property investors therefore choose to use "interest only" loans for the purchase of investment properties, and would choose to use any spare cash flow to pay interest on an additional investment property rather than pay off principal on one of their investment properties. Not to say that this is the best option for all investors, or even most real estate investors, but it just goes to show that paying off the morgage as fast as possible doesn't apply in all situations either.

Enough Wealth

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