Prepaying loan interest can be a double-edged sword.

Everyone likes a tax deduction. A big part of the marketing push from margin lenders is the ability to claim a tax deduction this financial year. The strategy is to prepay the interest on the loan for the next 12 months and claim a tax deduction in the current financial year. Many lenders also allow prepayment of interest on investment property loans.

But a closer look at the strategy shows the possible benefits might, in fact, have drawbacks. Under the tax laws, if the interest expense is greater than the income earned on the investment, the difference can be used to reduce the investor’s taxable income.

The maximum prepayment period allowed is 12 months and the interest rate for the 12-month period has to be known in advance, which means it must be a fixed rate of interest. One possible advantage of the strategy is investors can lock in the interest rate for the following year. Most economists say interest rates are likely to rise during the second half of this year.

A higher cash rate will increase variable interest rates on loans and will force 12-month fixed rates higher.

Many lenders also offer discounts on fixed interest rates when the interest is prepaid. Margin lenders typically offer a discount of 0.1 per cent. The Commonwealth Bank, on its property investment loans, offers a discount of 0.2 per cent.

The decision on whether to prepay or not depends on the investor’s total tax position, says a tax partner with HLB Mann Judd in Sydney, Peter Bembrick.

From July 1, most people will be paying more tax on their income. Under the flood levy, those earning taxable income of more than $50,000 a year will pay an extra 0.5 per cent on their income and those on more than $100,000 will pay 1 per cent more.

Prepaying interest is a way of bringing forward a tax saving that would have been claimed the next financial year.

”As income tax is going up by a small degree next financial year for most people, it may be better to let the deductions fall into the next financial year,” Bembrick says.

The head of technical services at financial planners Count Financial, Kim Guest, says the advantages of prepaying are, at best, marginal for most people but a ”prepayment strategy can work particularly well if the investor has an unusually high taxable income in this financial year”. That may be because the investor has sold an investment this financial year and has realised assessable capital gains, she says.

However, in order to prepay interest, the investor has to come up with the cash to make the prepayment in the first place. And by prepaying, the investor is locking in to prepaying each year.

”If the investors swaps back to paying interest normally, then there will be a year in which the investor receives no deduction,” she says.

The money used to prepay interest could be used instead to help pay down the mortgage on the family home, on which the interest payments are not tax-deductible, Guest says.

Posted by John Collett – The Age on 8th June, 2011