Interest in advance.
If you have an investment loan, you may be able to save money and streamline your cashflow by paying next year’s interest in advance.
According to Madhu Ramana, CEO of Zinger Finance, most people don’t know this option is available – yet there are plenty of people who would benefit from it.
How does it work?
If you have a property loan debt, it may be possible to refinance with an applicable financial institution and pay the interest component for the next financial year in advance.
For instance, if you had a loan as of May 2019, you could choose to pay interest from the 1st of July 2019 to the 30th of June 2020 as a lump sum payment.
To do this, you would need to refinance to a fixed rate loan that includes this option. So, if you have a variable rate loan with a bank that offers it, you would just need to do a product switch.
If you are already on a fixed rate loan, you would need to break the contract in order to refinance. This would mean paying any applicable penalties such as early exit fees.
If your lender doesn’t provide this option, you would need to refinance to a different institution that does.
You can only pay 12 months’ interest in advance and the arrangement is done on a year on year basis.
How does it help you save money?
Madhu says that lenders reward you with a discounted interest rate if you pay interest in advance. This means you are able to save a decent chunk of money out of your usual outgoings.
He says the amount of discount depends on the loan size and a range of other considerations, but he has found that during the past the discount has ranged from about 0.15% to 0.3% – though this is no guarantee in the current market.
How does it affect your tax?
By paying next year’s interest in advance, it is possible to claim it as a tax deduction in the current financial year.
Madhu says it is important to work closely with a good accountant and financial planner when using this strategy as there are certain terms and conditions as to who can benefit from it.
What are the strengths of this strategy?
One advantage is that it helps to streamline your cashflow. You don’t have to worry about making monthly repayments because you have already paid it in full for the year.
Madhu says this can be particularly helpful for self-employed people. If they have earned quite a lot of revenue during the year and forecast a tighter year ahead, paying interest in advance means they don’t have to worry about their monthly repayment obligation.
Higher income earners who get paid dividends, bonuses or franking credits can also use this strategy in order to get tax breaks. After exhausting excess capital by paying interest in advance, it is likely they will receive a good portion of it back in the form of a tax refund.
And, since you get a discounted rate by paying it in advance, you end up spending less money on interest. This can help your serviceability if you want to apply for another loan.
Who can benefit from paying interest in advance?
Aside from helping high income earners and self-employed individuals, Madhu says this strategy can also help investors with large portfolios.
Those who are getting close to maxing out on the amount of money they can borrow can often use this strategy to their advantage. Not only does it allow them to structure capital in a tax effective way, it also improves their credit rating dramatically.
How does it improve your credit rating?
In the current finance environment, lending history is very important says Madhu.
If you apply for a new loan, it is most likely you will have to provide a six-month lending history that shows you have made every repayment in full and on time.
“If you miss one repayment, the bank is not going to lend you money for at least a period of six months,” says Madhu.
Banks really like it if you have already paid the next year’s interest in full.
“You’ve paid off 12 months in advance so there are no arrears – your account is in mint condition,” he says.
This improves your credit rating to the extent where most banks will happily lend to you as long as you meet the rest of the criteria.
The downside of paying interest in advance.
The only weakness of this approach, says Madhu, is that it means parting with a big chunk of capital.
Depending on your strategy as an investor, this may affect how much money you can put into your next deposit.
But, if you are a sophisticated investor who works closely with your accountant and financial planner, you should be able to identify how much capital you can part with in the lead up to EOFY, as well as how much tax you will get back in return. This can help you decide whether paying interest in advance is the right strategy for you.
Madhu says that aggressive investors who are constantly negotiating on deals would probably not benefit from this approach. Since they always need to have capital at their disposal, paying interest in advance would be counterproductive to their strategy.
If you are not sure whether this strategy would work for you, the best thing you can do is talk with your accountant and financial planner as well as a finance strategist who knows how to build a property portfolio.