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It is not unusual for people to at some time have either a lump sum of money or be in a position to make more than the minimum repayment on their loans. This raises the question of whether you should make additional repayments or not?

Unfortunately the answer is not straightforward. It will depend on your personal circumstances and your understanding of investments and risk. Before proceeding we recommend that you have read the section entitled ‘Repayments - Principal & Interest or Interest Only?’

Given that your loan is not a regulated loan as described above you will have the choice as to whether your repayments are principal & interest or interest only. The answer will depend totally on your personal situation, understanding of investments, and preference for risk. It is based on the following question:

The concept here is to ask yourself whether you believe you could pay your loan off faster by investing the money into an investment that pays a high enough return that you could eventually redeem the money and pay off the loan sooner than if you had simply paid the loan itself off with that same money.

A Worked Example

You currently owe $100 000 on your own home at an interest rate of 10% (non tax deductible).. You then inherit $100 000. You also believe you can safely invest it and earn a 15% return after tax. What should you do?

If you pay the $100 000 off your home loan you will only owe nothing. This effectively saves you interest of 10% per annum after tax, or $10 000 per annum. But you have no cash or loan.

If you invest the $100 000 and earn a return on your investment of 15% after tax, then you will have $15 000 each year after tax. Not only does this cover the $10 000 interest you have to pay on your loan, but it gives you an extra $5 000 you can pay off the principal. So at the end of the year you will have paid the interest on the loan, could still pay off the $100 000 by redeeming the investment, and now have an extra $5 000 in your pocket you would not have had if you had just paid the loan off.

In the above example you end up with more total wealth through the investment than if you paid off the loan directly.

It is important to remember that if the investment underperformed you may end up worse off than had you simply paid off the loan!

That is why this decision is different for every individual based on your ability to understand and access investments and your tolerance for risk. We recommend you speak to a qualified professional to assist you in this matter.

The Decision Point Revisited

Whilst the above example is clear cut it is simplified. In real life it gets more complicated. The following are a sample of the questions you need to ask:

• Is the interest on the loan tax deductible or not?
• How much tax will I pay on the investment and any earnings?
• How much do you understand the risks of different types of investments? What sort of returns are they expected to pay and over what time frame?

This is why there is no straight forward answer to the question of whether you should make principal repayments or not.

As a simple rule, if the interest on your loan is tax deductible then you need to get a return before tax on the investment greater than your interest rate to be ahead.

Why? If you receive a tax deduction for your interest of 7%, and earn a taxable return on your investment of 7%, then they balance each other out and you are square. But if the investment returns any more than that then you are further ahead than if you had paid off the loan.

If your interest is NOT tax deductible the same principal applies but as your loan interest is not tax deductible you must have an after tax return on your investment equal to the loan interest rate. So in effect, the higher the tax bracket you are on, the higher the pre-tax return you need to achieve the same after tax return. The important thing to remember is that paying off non-deductible debt is a 100% safe way to get an effective after tax return equal to your interest rate. However any investment will involve an element of risk!

A Third Strategy for Non Tax Deductible Debt

Using the above example there is a third scenario that is actually superior. Simply put the solution is to repay the loan of $100 000, then re-borrow the $100 000 for investment, and still make the investment at 15% return.

Why is this superior? You still have the $100 000 investment returning $15 000 per annum after tax, but the $100 000 is technically no longer a loan against your own home but now an investment loan! Thus the $10 000 is now tax deductible to you and you will get a partial refund as opposed to having to pay the whole $10 000 after tax.

You must actually repay the loan and then redraw it for investment otherwise the loan will still be treated as a home loan and not tax deductible. Again it is recommended that you seek professional advice to help you with the correct strategy for your situation.

If you only have small amounts and tend to leave them in the bank then you are better off paying them off the loan, especially if you have a redraw facility. Also some mortgages have Mortgage Offset accounts where every dollar in them offsets the interest on your loan. These can be used to accumulate funds until it is worthwhile making a larger repayment and potentially redrawing for investment.