BORROWING STRATEGIES
CASE STUDY: The Browns are retiring in 10 years and have a $150,000 investment loan, which they would like to have paid off when they retire. There are two strategies open to them. The first is to take out a $150,000 P&I loan, on which the monthly payments will be $1742 if the interest rate is 7%. The problem with this approach is that they will incur only $59,000 of tax deductible interest during the course of the loan and, as each year goes by, a larger and larger portion of their monthly payment will be coming from after-tax dollars, because the interest component is reducing rapidly.
The other strategy also involves paying $1742 a month, but in this case, the loan is kept on an interest only basis, which will require payments of $875 a month, and the remainder of the money available, i.e. $867 a month, is placed into an insurance bond fund. If the bond fund returns 8% per annum it will be worth $158,000 in 10 years, when it can be cashed in tax-free.
Because the loan balance doesn’t reduce the tax benefits are maintained. Notice over 10 years both strategies will involve total payments of $209,040 ($1742 a month for 10 years), but with the first strategy the tax deductions are just $59,000, with the second strategy, they are $105,000. For a top rate taxpayer strategy one provides after tax benefits of $28,615 ($59,000 x 48.5%) whereas strategy two provides $50,925 ($105,000 x 48.5%). The difference is worth nearly 15% of the $150,000 borrowed.
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