Should I prepay my margin loan before June 30?
Paying loan interest in advance can be a smart tax strategy.
As margin loans are used to invest in shares, the loan interest can normally be claimed on tax. Better yet, it's possible to claim up to 12 months' worth of interest paid in advance, bringing forward a tax deduction to those years when your income is expected to be higher.
Prepaying interest is only possible if you have a fixed rate margin loan. That way, the interest cost is known in advance.
To understand the potential benefits of prepaying interest, let's say a hypothetical investor - Kate, has a margin loan for $50,000. She has a fixed rate of 5.5%, so the annual interest cost is $2750.
In the current (2019/20) financial year, Kate expects to earn taxable income of $120,000. However, from July 2020, she plans to take 12 months unpaid leave to complete full-time study. This will see her income drop to about $18,000 in 2020/21.
By prepaying 12 months of loan interest ($2750) before June 30, 2020, Kate can cut her 2019/20 personal tax bill (including Medicare) by $1155. If she waits until the following financial year to pay interest, Kate will receive zero tax saving as her income is below the taxable threshold of $18,200.
While this is an extreme example, there can be plenty of times when personal income is higher in one financial year than the next. You may receive a large bonus this year, or conversely, you may be heading off on maternity leave in the following financial year.
An opportunity to pay a lower rate
Along with tax savings, prepaying loan interest can be a chance to score a solid rate discount. As a guide, margin lender Leverage has a variable loan rate of 6.45%. But if you pay 12 months of interest in advance, the fixed rate can fall to 5.49% - or even as low as 3.99% depending on the size of your loan.
As always, there are downsides to consider. Prepaid interest isn't normally refundable. So if you sell up your portfolio and pay off the loan, you're unlikely to get any prepaid interest back. Moreover, bailing out of a fixed rate loan early can see your lender charge break costs. It means you need to be confident of holding onto your geared share portfolio for at least another year.
The biggest drawback of prepaying is that you need to have the cash on hand to pay a year's worth of interest upfront. For some margin loan investors, this could be challenging right now.
Earlier this year, between February and March, the Aussie sharemarket plunged 36%. A fall of this magnitude would have seen plenty of margin loan investors receive a dreaded 'margin call'. That's when the lender gets in touch, asking you to bring the loan back to its original lending ratio - often 75%.
Margin calls can be managed in several ways - either by reducing the loan balance, selling some shares (potentially at a loss), or offering additional shares as loan security. Investors who opted to pay down part of their loan could be facing an unexpected cash squeeze.
That said, if you have the funds available, and it looks as though you'll earn less next financial year, prepaying margin loan interest can be a way to pocket tax savings and potentially secure a lower rate. The key is to speak to your tax adviser to be sure that prepaying is the right strategy for you.