Margin Loan - Prepay/Capitalise-HELP!

Discussion in 'Share Investing Strategies, Theories & Education' started by PennyWise, 26th Jun, 2007.

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  1. PennyWise

    PennyWise Active Member

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    Hi All,

    Can someone explain in simple terms what the pros/cons and differences are between prepaying interest on a margin loan from an existing loan and prepaying and capitalising the interest on an existing loan?

    One seems to be that the interest is added to the loan and the other seems to be interest and interest on interest plus some factor.

    I thought I understood it after reading through the forums but after several quotes and phone calls to BT this week I'm more confused than ever as they give me a different explanation each time! :confused:

    Grateful for any help and assistance here as I have to finalise this week.

    Thanx in advance,

    PW
     
    PennyWise, 26th Jun, 2007
    #1
  2. Simon Hampel

    Simon Hampel Founder Staff Member

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    It's pretty simple really. If you borrow money to pay interest you are capitalising that interest cost - which means you will pay interest on that borrowing in future (compounding interest costs).

    It doesn't matter where the borrowed money comes from (margin loan, home equity loan, other loan) ... it's the same basic result, differing only by the amount of interest you pay (assuming the loans have different interest rates).

    The thing that is probably the most confusing is the terminology that people use - I find the inconsistencies in what people call things cause more problems than anything else.
     
    Simon Hampel, 26th Jun, 2007
    #2
  3. PennyWise

    PennyWise Active Member

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    Hi Sim,

    Yes that was what I thought but BT have at least two options for prepaying.

    1. They take the prepaid interest from your existing margin loan funds which increases the loan balance eg: say it was 10% prepaid interest then $100k ML becomes a $110K ML.

    2 The other option they call compounding in which they add the interest and the interest on the interest to you existing ML plus some other x factor which again increases the loan balance eg: say it was 10% again then prepaid interest on $100k ML becomes $110K plus $1K plus x. Where x is some additional factor, in my case a couple of hundred dollars!

    This is what I'm having difficulty with. Why would one opt for option 2 over option 1? Is there some benefit to option 2 that I'm missing? On face value it seems to be much the same but at greater cost.

    Cheers,

    PW
     
    PennyWise, 26th Jun, 2007
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  4. Glebe

    Glebe Well-Known Member

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    They both sound like capitalising options, but option 1 is prepaying (or capitalising) for a set duration upfront (eg June 2007 - June 2008), whereas option 2 is pro-rata'ed (eg monthly in arrears).

    That being said, I don't understand the "$110K plus $1K plus x.'' stuff...
     
    Glebe, 26th Jun, 2007
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  5. Simon Hampel

    Simon Hampel Founder Staff Member

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    I would say that with option 1, you will have to still pay the interest on the pre-paid interest.

    ie. Loan of $100K, interest on $100K @ 10% = $10K, new loan balance $110K, so for the next 12 months, you've already paid the interest on the $100K, but you haven't paid the interest on the $10K you borrowed to pay the interest with - you'll need to pay that extra interest during over the course of the year, like you would with a normal margin loan (it won't be much though).

    With option 2, I'm guessing they are capitalising the interest on that interest too (both the $10K interest, plus next year's interest on that $10K is capitalised), so there's no extra cost to you during the year.

    At least I think that's what they are doing!!
     
    Simon Hampel, 26th Jun, 2007
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  6. PennyWise

    PennyWise Active Member

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    Hi Guys,

    Yes that makes sense Sim however I don't understand this extra amount (X) that they adding onto the compounding option.

    i would have though the prepaid interest amount would apply to both components ie: the interest on the ML and the interest on the interest of the ML.

    It's like they are using a different rate for the interest on the interest!

    Will call BT again tomorrow and probably end up getting get several different answers again. :(

    Interested to hear from anybody elses experience who has taken the prepaid compound/capitalise option with an ML.

    Cheers,

    PW
     
    PennyWise, 26th Jun, 2007
    #6
  7. Simon Hampel

    Simon Hampel Founder Staff Member

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    If you think about it ... the cost of capitalising prepaid interest is actually an infinitely recursive figure (although it does tend towards zero the further you go)

    Eg. Loan $100K, capitalised interest @ 10% = $10K
    +Prepaid capitalised interest on $10K @ 10% = $1K
    +Prepaid capitalised interest on $1K @ 10% = $100
    +Prepaid capitalised interest on $100 @ 10% = $10
    +Prepaid capitalised interest on $10 @ 10% = $1
    +Prepaid capitalised interest on $1 @ 10% = $0.10
    +Prepaid capitalised interest on $0.10 @ 10% = $0.01
    +Prepaid capitalised interest on $0.01 @ 10% = $0.001 (ignored due to rounding)

    ... so the actual amount added to your load should be $10,000 + $1,000 + $100 + $10 + $1 + $0.10 + $0.01 = new loan balance of $111,111.11

    That's the effect of compound interest!
     
    Simon Hampel, 27th Jun, 2007
    #7
  8. PennyWise

    PennyWise Active Member

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    X factor explained!

    Good work Sim, that pretty much accounts for the extra amount on the capitalised loan quote.

    It's a shame the 'experts' at BT aren't able to explain how there loans are calculated.

    Thanks for your help.

    Cheers.

    PW
     
    PennyWise, 27th Jun, 2007
    #8
  9. JamesGG

    JamesGG Member

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    Hiya,

    While Sim' has explained what BT are trying to do for you, the other thing worth considering is if you choose to run with option one, are you able to do so year in, year out?

    If you choose to capitalise and prepay your interest this year, but not next year, you could find yourself with (hopefully) a sizable income from the product, but, no interest to offset it with because you paid for it all last year.

    Just something else to complicate things for you :p

    Cheers

    James.
     
    JamesGG, 3rd Jul, 2007
    #9
  10. DaveA__

    DaveA__ Well-Known Member

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    this is where tax planning comes into it, if you are giving up work next year, its best to get all expenses this year, same if you plan to drop an income bracket, or have a trust (where a beneficary is turning 18)

    if you are planning on selling assets attracting large captial gains, then it maybe best to defer the expense to next year where it will make more of a deduction (40% instead of 30%)....

    as normal... usually disclaimer...
     
    DaveA__, 3rd Jul, 2007
    #10
  11. JamesGG

    JamesGG Member

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    Hiya,

    Precisely my point, Dave. It can be a great way to reduce tax in the current year, but, you do need to think ahead to future years, too...

    Cheers

    James.
     
    JamesGG, 4th Jul, 2007
    #11
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