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This month, Michelle Griffiths answers a great question about how to best manage home loan and investment loan repayments.
I have a home loan and an investment loan. The investment loan has a higher interest rate. I have recently come into some money and would like to reduce my debt. Which loan should I pay off first?
It is quite common for home loan interest rates to be lower than investment loans (often around 0.5% different). It is natural to think that you should reduce the loan with the higher interest rate – but this is in fact not the best thing to do in most instances. Let me walk you through the logic of this.
I like to talk about the fact that there is good debt and bad debt.
Good debt relates to investment loans where the interest is tax-deductible.
Bad debt is any loans that are not tax-deductible. This is usually for the purchase of assets that are not related to investment or income-producing purposes – for example, home loans, car loans, personal loans for personal expenditure items.
Generally, you should always focus on paying off your bad debt first. Even though the interest rate on these loans may be less than those for investment loans, when you take into account the tax-deductible nature of the investment loans, there is usually not much benefit in paying these off whilst you still have bad debt to deal with.
Here is a simple example. You have a home loan with an interest rate of 2.5% and an investment loan with an interest rate of 2.9%. You want to pay $100,000 off one of the loans.
The table below gives a comparison between the two options.
Although the interest rate is higher on the investment loan, the net interest cost in the table shows that when you include the tax implications, it makes sense to pay off the home loan first.
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Disclaimer: The information contained is general in nature. Professional advice should be sought before acting on any aspect on this page. Financial planning services provided by TAG Financial Advisors Pty Ltd (ABN 77 154 205 017 AFSL 415632), a wholly owned subsidiary of TAG Financial Services Pty Ltd (ABN 67 075 374 686). Copyright 2022. Please do not reproduce without the expressed written consent of the author.