Mistakes Made With the Use of Lines of Credits

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line of credit

There is a critical mistake made by many people who have lines of credit and who have investment properties.

This mistake is common and you’ve got to be aware of it, because it’s costly to fix up.

As you know a line of credit (LOC) is like a big credit card.

The banks give you approval for a limit on how much you can spend, and you can spend it anywhere you like.

Many people use it like a business uses an overdraft and you only pay interest on the debt that’s outstanding at a point in time.

You can pay private or investment expenses with it and some even use it to pay off their credit cards.

Since a Line of Credit is normally secured against your home the interest rate is quite favorable because it’s at a home loan rate and not an investment loan rate nor at a credit card rate.

So it’s better to pay that credit card debt off with your Line of Credit as it’s at a cheaper interest rate.

TYPICAL SCENARIO

Let’s imagine someone gets a line of credit (LOC) of $100,000, and they’ve used that $100,000 as the 20% deposit and stamp duty to purchase a property.

So it’s now an Investment LOC and the interest is tax deductible.

The interest on the LOC is tax-deductible because the money went towards the investment property.

HERE’S WHERE THEY MAKE A MISTAKE…

They bank their wages into that line of credit, because their banker or their broker tells them:

“It’s a great idea, because it will save you interest whilst your wages is sitting there having reduced the amount of the debt and therefore the amount of interest that’s Payable on the LOC.

Isn’t that what most people are told and you may have been told this also.

PUT ALL EXPENSES ON A CREDIT CARD

Many people are also told to get a “credit card” and put all of their personal expenses on it, then pay it off once a month.

So you’ve got your wages sitting in your line of credit, reducing the interest you have to pay on your LOC and then you put all your expenses on your credit card.

This gives you 55 days interest free, and on the 54th day or 55th day, you transfer the money from your line of credit and pay down your credit card.

HUGE PROBLEM

The problem with that is you just changed the “purpose” of your loan.

The original purpose of the loan was taken out as a deposit towards an investment property and the interest is therefore a tax deduction.

12 MONTHS SCENARIO

Over 12 months you put your wages into your line of credit and let’s say your wages was $5,000 a month or $60,000 in total over 12 months that was deposited into your LOC.

Effectively you have reduced your line of credit down to $40,000, and let’s assume over 12 months your credit card payments totalled $60,000.

Once you have repaid your credit cards of $60,000 your line of credit is now back up to $100,000 owing.

But you have saved the interest on your $60,000 wages whilst it is sitting in the line of credit.

Surely that must be a good thing?

CHANGED PURPOSE OF LOAN

As the original loan of $100,000 was used as a deposit and stamp duty for an investment property and therefore the interest is tax deductible.

When you paid $60,000 off your LOC (whilst your wages is sitting in your LOC) but when the LOC was used to pay off your credit card debt (all private expenses) you changed the purpose of your loan from an investment loan (tax deductible) into a private loan (not deductible).

PURPOSE OF THE LOAN DETERMINES DEDUCTIBILITY

The tax department looks at where your money “went to” and the “purpose of that loan” to determine whether the interest is tax deductible or not.

Even though your LOC is still $100,000 owing after 12 months but now you can only claim 40% of the interest instead of the original 100% of the interest because you paid $60,000 off the original deductible loan (leaving $40,000 investment loan) and replaced it with a private loan when you paid $60,000 off your private credit cards.

And to make things worse, your accountant will probably spend thousands of dollars trying to work out what portion is deductible and what portion is private and not deductible.

You need to be very careful with this as it’s an easy trap to fall into.

SO WHAT SHOULD YOU DO?

Have two lines of credit.

For example, if you have a business or an investment line of credit, and that’s say $100,000, you simply leave that alone.

A SECOND PRIVATE LOC

You might also have a second but private line of credit for your private mortgage, and it might be for say $90,000 (example)

This is where you deposit your wages and you pay your credit cards from which could make up part of your private home loan also.

AN OFFSET ACCOUNT

You can also have an offset account setup where your wages is being deposited into and you pay your credit cards from but also the interest on your investment LOC can be offset against this account.

If you have any specific questions about the deductibility of your LOC or changing the purpose of your loan please talk to your Chan & Naylor Partner or your personal Client Managers who are all suitably qualified to answer your questions.

Ed Chan - Chan & Naylor


Disclaimer: This article contains general information; before you make any financial or investment decision you should seek professional advice to take into account your individual objectives, financial situation and individual needs. Click for more detail regarding this disclaimer.

2 responses to “Mistakes Made With the Use of Lines of Credits”

  1. Vanessa Woo says:

    Thanks Ed for the article. So well written and easy to understand. I was one of those who thought to park all my income into the one Line of Credit initially to save on interest. Thankfully you have great staff who advised me to structure it differently.

    • Marco De Gouveia says:

      Hi Vanessa;

      Hope all is well with you.

      Ed said to thank you for your kind comments and it’s good to know our staff are guiding you correctly.

      Best Regards;
      Venus

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