Did you know that two loans that look identical can have a radically different impact on your financial management? The difference lies in whether interest on a loan is deductible or not.
Not all debt is the same. Even if the interest rate is.
One of the main differentiators between debt is whether or not you can claim a deduction for the interest. If interest is not deductible, then the interest rate paid is much higher than you might think.
When interest is not deductible, you have to pay tax before you pay the interest. You can see this with an example: If your nominal interest rate is 5%, and you are a 45% taxpayer (the highest tax bracket), the effective interest rate around 9% before tax. To understand this, consider an interest bill of $5000. A person paying tax at 45% has to earn $9000 in order to pay this bill. Of this $9000, they pay $4050 in tax to the tax office, leaving (virtually) $5000 remaining to pay the interest.
When interest is deductible, you don’t have to pay tax before you pay the interest. So you only have to earn $5000 to pay an interest bill of $5000. Here is the effective rate of interest on non-deductible debt for different levels of income:
|Income||Marginal tax rate||Effective interest rate on a 5% loan|
The effective interest rate can also be thought of as the ‘pre-tax’ interest rate.
The above table shows the effective pre-tax interest rates for a relatively low nominal interest rate of 5%. If the nominal interest rate is higher than these rates, then the effective pre-tax interest rate will also be much higher. Things can get really out of hand when it comes to credit card debt, with a nominal interest rate can be as high as 16 or 17%. For an average income earner, with a marginal tax rate of 32.5%, the effective pre-tax rate of interest becomes 25% if the nominal interest rate is 17%.
Repaying non-deductible debt is usually your best investment
Repaying non-deductible debt is usually your best investment. When you make an investment, you have to pay tax on the return. Therefore, investment returns should always be thought of as ‘pre-tax’ rates of return.
When you retire debt, you are guaranteed to no longer have to pay interest on that debt. A dollar saved is a dollar earned. Therefore, the interest that you save has the same financial effect as a return that you might achieve if you invested the same money. And, when the interest is non-deductible, the interest that you save is the same financial effect as the pre-tax rate of return on any investment.
As the table above shows, the effective pre-tax interest rate increases as your marginal tax rate increases. An investment return of (say) 7.9% is quite a good return. It becomes even better when that rate of return is assured – as it is when the return is achieved by reducing a definite expense such as interest.
That is why retiring non-deductible debt should actually be considered as an investment. What’s more, retiring non-deductible debt is probably the first investment that you should make. Paying off non-deductible debt frees you up to concentrate all your future efforts on wealth creation.
What sort of interest is non-deductible?
Non-deductible interest is interest on any debt taken on for private reasons. The main form of this debt if often a home loan – a loan taken out to buy the home you are living in. Loans for cars, boats, renovations, school fees or anything else that is not used in the course of generating income is non-deductible. Credit cards used for private consumption also lead to non-deductible interest – although you should be repaying the credit card each month and avoiding interest altogether.
What about when debt is deductible?
Deductible debt is a different matter. Deductible debt should only really be repaid if there is nothing ‘better’ to do with your money. Economic theory tells us that the rate of investment return on representative assets should exceed the cost of borrowing over the long term. So, rather than retire deductible debt, it can often make sense to use any ‘excess’ cash flow to fund extra investments.
The short term impact on your net assets will be the same. Net assets are your total assets minus your total debts. If you use the same amount of money to either repay debt or buy more assets, the net assets figure does not change. However, if the asset that you buy grows by more than the debt that you retain, then over time your assets will grow by more than your debt – making your net assets a larger figure.
The tax advice component of this article was produced by Dover Financial Advisers, a registered tax (financial) adviser.