Understanding capital protected loans

The latest federal budget has reminded investors interested in using a capital protected loan to take full account of the special tax rules that apply.

The key feature of these loans is the guarantee that, should your investments fail, you won't lose more than the amount you actually invested.

That is, you won't be left having to repay the amount you borrowed. The cost of this guarantee is a much higher interest rate - usually twice that of non-protected loans, and sometimes even higher.

Despite this extra cost the loans initially attracted plenty of support partly because all of the interest charged on loans that had received a tax office product ruling often was fully tax deductible.

Since 2003, however, there has been a series of twists and turns as the tax office and federal government assessed and reassessed their approach to taxing these loans.

The harshest blow came in May 2008 with the ruling that interest in excess of the Reserve Bank's indicator variable rate for housing loans - at present 7.15 percent - would no longer be tax deductible. Previously the benchmark was more generous being set at the indicator variable rate for personal unsecured loans, currently 14.75 percent.

In its latest budget the federal government has again varied the benchmark rate setting it at the variable housing loan rate plus one percentage point.

While better than nothing, it is a very modest concession, which means the after-tax cost of capital protected loans remains extremely high.

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