Debt or borrowed money can play a significant role in helping you achieve your lifestyle goals. However, it is important that debt is managed and structured effectively to minimise borrowing costs.

For most of us kiwis, the family home accounts for a substantial proportion of our total wealth. It’s therefore not surprising that loan repayments attached to the home can often account for significant outlays each month. Speaking to a Financial Planner can often unlock savings for clients that are achieved through structuring their debt more efficiently.

How can a Financial Planner help?

A Financial Planner can assist you in implementing debt management strategies that could:

  • Help you pay off your loan sooner
  • minimise the interest paid on borrowed funds
  • improve your month on month cash flow position, reducing the burden of minimum repayment amounts
  • potentially provide you with more cash flow at the end of your loan term that can either be used to repay other debt or to make additional investments

Our AIFP Financial Planners can assist you with specific credit product advice such as:

  • Determining your specific funding requirements
  • Helping you chose from a wide variety of lenders
  • Securing a loan with more favourable fees, lending terms or interest rate
  • Submitting the loan paperwork
  • Liaising with the lender/conveyancer/solicitor

Debt Management in Practice

To demonstrate how debt management advice assists our clients, a hypothetical scenario is presented below.

Hypothetical case study: Consolidating debt for Jill and Ben

The situation

Jill and Ben are fictitious young professionals. Their situation is as follows:

  • Purchased their first home in 2009 for $650,000 funded through a home loan. They currently owe $370,000 at 5.5% interest.
  • Married in 2013 costing $46,000 funded through a personal loan. $20,000 currently owing at 15% interest.
  • Recently returned from an extended overseas holiday costing $15,000 paid for on Jill’s personal credit card. Currently owing $10,000 at 19% interest.
Loan Home Loan Personal Loan Credit Card Total
Balance $370,000 $20,000 $10,000 $400,000
Rate 5.50% 15% 19%
Remaining term 25 years 5 years No term
Monthly repayment $2,275 $425 $300 $3,000
Total interest $311,275 $8,547 $4,342 $324,164

The potential strategy

Through debt consolidation, Jill and Ben could transfer their existing credit card debt (19% interest) and personal loan debt (15% interest) to their home loan (5% interest) in order to take advantage of a lower interest rate.  By consolidating their debts they could:

  • Pay off all their debt 7.7 years sooner (assuming they continue to pay $3,000 a month)
  • Reduce the amount of interest paid over the term of the loan by $120,061 (assuming they continue to pay $3,000 a month)
  • Reduce their monthly minimum repayments ($3,000 down to $2,456 a month) to free up cash flow for other purposes
Current Minimum repayment Maintain existing
Loan amount $400,000 $400,000 $400,000
Monthly repayment $3,000 p/m $2,456 p/m $3,000 p/m
Interest $324,164 $346,780 $226,719
Term 25 years 17.3 years

FAQs

I’ve read an offset account can save me money. What’s an offset account?

A 100% offset account can be operated as your normal transaction account, ensuring you retain complete flexibility and access to your funds. When your interest is calculated, the funds held in this account are ’offset’ against your loan, effectively reducing your interest liability. Using an offset account to its optimum involves keeping all your income and any savings in this account for as long as possible. This effectively minimises the daily balance owing used to calculate your loan interest and as a result, can also reduce the term of your loan.

If you have an investment loan, there is an advantage in making additional repayments into an offset account rather than making the repayments directly into the investment loan. While in both cases you will reduce the effective loan balance and save interest, you are able to withdraw funds from the offset account whilst maintaining full tax deductibility of interest on your loan.

Be aware you may have to pay a fee or higher interest rates for this facility.

I’ve read an offset account can save me money. What’s an offset account?

A 100% offset account can be operated as your normal transaction account, ensuring you retain complete flexibility and access to your funds. When your interest is calculated, the funds held in this account are ’offset’ against your loan, effectively reducing your interest liability. Using an offset account to its optimum involves keeping all your income and any savings in this account for as long as possible. This effectively minimises the daily balance owing used to calculate your loan interest and as a result, can also reduce the term of your loan.

If you have an investment loan, there is an advantage in making additional repayments into an offset account rather than making the repayments directly into the investment loan. While in both cases you will reduce the effective loan balance and save interest, you are able to withdraw funds from the offset account whilst maintaining full tax deductibility of interest on your loan.

Be aware you may have to pay a fee or higher interest rates for this facility.

I’ve heard people use the terms “good debt” and “bad debt”. Could you elaborate?

Good debt refers to using borrowed money to purchase assets that generate income. It’s called “good debt” because the asset’s income should improve your total wealth over time and the interest on the loan may be tax deductable.

Bad debt refers to using borrowed money to purchase non-income generating items like clothes and holidays. Whilst they may be enjoyable or even necessary, this sort of debt is unlikely to generate income, be tax deductible, or improve your total wealth.

What is debt recycling?

In some cases, it may be appropriate to consider replacing inefficient debt with more efficient debt that can be used to create wealth tax effectively. This strategy is known as debt recycling but should only be undertaken after a thorough analysis of your financial situation. Debt recycling can be an effective strategy to accumulate wealth over the long-term. It is a process of using surplus capital or cashflow to reduce inefficient debt and then replacing it with efficient debt in the form of an investment loan. The investment loan proceeds are then invested to form part of your investment portfolio. The inefficient debt is eventually extinguished and an investment loan with fully tax deductible interest remains. There is no tax benefit available on debt used for personal purposes, but a tax deduction is available on the interest expense on investment loans where the loan is used to purchase income producing assets. Debt recycling therefore results in a more tax efficient outcome and wealth accumulation benefits through the accumulation of an investment portfolio. Note the investment loan would need to be repaid at some point in time.