Redrawing of loan

Well said Simon.

If you had a home and an investment property, you would be better of with the LOC being against your home, since the interest paid on a PPOR is non-deductible.

For example, let's say that you had three choices with your $5,000 monthly pay packet:

1. Put In The Bank

You could put it in an interest bearing account and draw it down.  You would earn interest, but this interest would be assessable for tax purposes, so the exact amount of the return would be ($Interest * (1-tax rate)).

For example, if you could earn 5% interest per annum, then assuming no drawdowns then you would earn $20.83 interest for the month.  Assuming you paid 30% average income tax, your after tax return would be $14.58 (which then equates to an after tax return of 3.5%.

2. Pay Off Your Investment Property Loan

Assuming you had an outstanding loan of $100k and interest was at 8% per annum, paying the $5k off your IP loan would save you $33.33 per month (using simple interest calcs). Since this saving is not taxed, it could be seen as an effective way of maximising wealth, EXCEPT that the interest here is tax deductible.

Had you paid the interest, then (say) 30% would have been deductible meaning that the tax shield would be $33.33 * 30%.

That is, the after tax effecive interest rate would be $23.33. This equates to an interest rate of 5.6%.

So, what seemed okay at first glance may not be so good afterall.

3. Pay Off Home Loan

Let's also imagine that you had a home loan of $100,000 with interest also at 8%.  This interest is non-deductible as the loan is for a private purpose.

If you pay off the $5,000 against the loan you still save $33.33 per month.  However, now:

A. The saving is not taxible (unlike option 1 where the interest was earned (not saved) and hence was taxable; or
B. The interest is not deducible (unlike option 2).

So, in order to earn $33.33 per month, you would need to gross $33.33 + (1- tax rate).  That is, in pre-tax salary you would need to earn $47.61, so that once tax was taken out you would end up with $33.33.

Therefore, now the tax effective interest earned is 11.4% (($47.61 * 12 )/ $5000).

Summary

Therefore, looking at the three interest rates that have been notionally adjusted for the impact of tax:

Option 1 yields 3.5%
Option 2 yields 5.6%
Option 3 yields 11.4%

This rather simple maths model (with the assumptions herein) reveals why it is usually more advantageous to pay off non-deductible debt first, then deductible debt, and lastly invest the money in separate interest earning accounts.

Cheers,