Interest Only with offset account structure

Jamie Moore

We see it every day. Clients who pay down a large portion of the loan on their Principle Place of Residency (PPOR) and are now looking to upgrade to a larger house while keeping their current property as an Investment Property (IP). 

So what's wrong with this picture? In short, when their current property turns into an IP, the loan against this property is generally quite small (as they've paid down a considerable amount of the principle) - which means they can only claim a small amount of interest. The good news is that there's a way around this - but it's important that it's set up correctly from the start!

Let's look at an example.


The not so ideal situation
John purchased his first home in 2005. It was a nice little 1 bedroom apartment in the centre of town. He took out a loan of $300k for it.

The loan was set-up as principle and interest and John was determined to pay off his loan as quickly as possible.

It's now 2011 and John has managed to get his loan down to $100k. 

John has now decided he would like to buy a larger house but keep his little one bedroom apartment as an investment.

Because John has paid his loan down to $100k - when this property becomes an IP, he can only claim interest on a $100k loan (which is about $7k per annum on 7% interest rates) which isn't ideal since the property is now worth about $500k and is going to get $500 per week rent.

To make matter worse, John wanted to use the equity in his first property to purchase his next one. The issue is that the equity he is accessing from his 1 bedroom apartment won't be deductible because it's being used to purchase a PPOR. 

So in this scenario, John has reduced his tax deductible (IP) debt whilst increasing his non-deductible (PPOR) debt. Not ideal!

So how do we get around this?

The ideal situation
If John had set up the loan as Interest Only (IO) with an offset from the beginning; he could have eliminated this issue.

Instead of paying down the principle, John could pop all of his spare money (including the would be principle repayments) into the offset account which provides a similar outcome to paying down the principle. Instead of having paid down his loan to $100k, John would have $200k sitting in his offset account and only paying interest on the remaining $100k.

When it comes time to convert this property into an IP, John can simply take the funds out of his offset account, which will boost the loan back up to $300k, and use those funds towards his next PPOR. This way, John has basically increased his deductible debt (IP loan) back to its original level of $300k whilst reducing his non-deductible debt (PPOR loan) by $200k.

Now John is able to claim interest on a $300k loan (which is closer to $21k per annum on 7% interest rates).

Get professional advice on your structure
I think it goes without saying. An IP savvy mortgage broker who deals with these scenarios daily would have set this up correctly from the start - saving John thousands. Make sure that you plan ahead! Not doing so could wind up costing you thousands.


Happy investing!


Jamie


About the author: Jamie Moore is an active residential property investor and owner of Pass Go Home Loans.