47 – How we saved 1 million dollars tax free

UsererYou may not have realised but the mortgage on your family home is one of the most flexible and safest “investment” vehicles available to you.

Let’s start at the beginning, with the basics. Say you take out an owner-occupier, principal and interest home loan from a bank for $750,000; the loan is for thirty years with a variable interest rate of 5.25%.

As an owner-occupier you’ll live in the home (note different factors, such as tax deductibility, are at play with an investment loan). Your interest rate will rise or fall depending on several factors, including the RBA’s official cash rate, regulatory changes—such as those implemented by APRA in recent years, market conditions, and the business outlook of the bank itself (such as exposure to business issues in other industries or countries).

As a principal and interest loan, you’ll start by paying off the interest (mainly) and your regular repayments will likely be about $4,100/month. You’ll pay that amount every month for thirty years. After 360 payments, you’ll have paid off the principal amount of $750k and nearly $750k again in interest.

So in a nutshell, your house will cost you twice as much as the price of the house itself if you take on a mortgage (I’m glossing over deposits and stamp duty, of course). That’s a lot of money!

This is why my #1 tip is to pay off your mortgage as soon as you can. To achieve this, negotiate annually with your bank to secure the best interest rate you can and move banks if you’re not happy; employ an offset account (don’t use redraw) to ensure all of your cash is being used to reduce the principal owing; switch to fortnightly or weekly repayments; throw everything you’ve got at your mortgage until it’s at least well under control if not obliterated—and by this I mean scrimp and save and defer buying the things you want for a few years.

Many banks and financial institutions offer interactive, visual calculators which demonstrate how changes in interest rates and repayment frequency will affect the total cost of your loan. Check out this calculator from CANSTAR, as one example. It was the looming threat of having to pay thousands of dollars every month, illustrated in a calculator like this, and the idea that our house would cost twice as much in interest, that drove me to our strategy of removing our home loan from our lives. 

Repayment Calculator

If you’ve got money squirrelled away elsewhere, it’s probably time to liquidate and toss it into you offset account. If you’re using a high interest savings account, the ATO will treat your earned savings as taxable income (which will be taxed at your marginal tax rate). The same goes for capital gains income from other investment vehicles such as stocks. Don’t forget your savings are also being eroded by inflation at a rate of ~3% every year—meaning your cash loses 3% of its value once every year to the point where you position is probably moving backwards.

Ask yourself if your other investments are earning you a return of 5% p.a. or more, after CPI and tax—where the 5% figure is taken from interest rate on your mortgage. You’ll likely find they’re not. Don’t forget to consider your risk exposure with these investments: when the next dotcom crash or GFC arrives, will your investments hold their current value?

By contrast, you live in your home and, while it’s not an income-producing asset, it is a huge (albeit generally low-risk) liability which will undermine your ability to purchase strong assets if not reduced. That said, no matter what happens, your house will provide you with shelter and warmth and privacy even if it drops in value or the worst happens: it’s something you can use.

Suppose you are taming the bear that is your mortgage: you’re chipping away at it using an offset account and making extra repayments. Meanwhile, the value of the security—the land on which your house sits—has likely increased in value. If you need a large amount of cash for that rainy day emergency, it’s immediately accessible to you from your offset account or by redrawing. In other words, your mortgage as a “reverse investment” (if that makes sense!) is not only low-risk but it’s fluid in that it can be rapidly converted into cash.

With the passage of time and increase in value of your property, you may now be able to take out a line of credit, effectively a mini-mortgage secured against the difference between the current value of your property and its original value or what’s been paid down (the equity but this is also called your “lazy money”—set it to work for you!). You could go silly and use this to fund a holiday or buy a fancy car but that would undo your hard work. Instead, use that available money to pay a deposit and costs for your first investment property. Welcome to the world of leverage.

The above is exactly what we did and we effectively paid down our mortgage in full in about eight years (ours was largely a dual-income family on average salaries for the majority of that time). From the line of credit, we’ve been able to extend ourselves into two investment properties, all the while saving somewhere between $500k – $1m in interest (depending on future interest rates), paying no additional tax, and watching the value of what is now our home increase rather than moving backwards, as cash would have.

I suppose a disclaimer is also worth posting: I'm just a guy, I'm not an accountant, lawyer, solicitor, tax agent, mortgage broker, banker, financial adviser, insurance agent, land developer, builder, government agent, or anything else so I disclaim your application of anything I write here is to be applied at your own risk. What I write may be incorrect and you are best to seek your own professional advice (tax, legal, financial, and otherwise) before entering into contracts or spending your money. Your situation is unique to you and what I write here reflects my experience only. This content is not professional advice and is not tailored to your situation. I’m not selling anything and I do not receive any form of commission or incentive payments for any companies or individuals I endorse. I'm learning too and expect to make many, many mistakes along the way.

Enjoy,

Michael

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