# Need help to understand and check my scenario calculations

Discussion in 'Accounting, Tax & Legal' started by bonkerrs, 25th Mar, 2008.

1. ### bonkerrsActive Member

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This thread is in regards to borrowing money to earn interest. There are a couple of things I've been wondering about for a while but haven't looked into. Now is the time for me to enquire.

I have created 2 scenarios on a spreadsheet which I'm not sure if it is correct... hope someone here can assist with the spreadsheet and help me better understand.

But first, can I post an Excel file here? If so, I'll attach it with my next post.

2. ### Simon HampelCo-founderStaff Member

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Yes you can.

3. ### bonkerrsActive Member

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OK here it is.

The following will make better sense with the spreadsheet opened...

The scenario in the spreadsheet has an initial investment amount (25,000) that is not borrowed. note: it seems wrong the invested amount can over double in 12 months

I need help working out a scenario where the initial investment (25,000) is borrowed (at 8.2%). If the money is borrowed for investment purposes, the interest paid for the investment loan is 100% tax deductible, right? This is where I am stuck... what do I need to consider? What will the returns look like with the introduction of the 8.2%?

If this is not enough info, please let me know. As I said in the post, I don't have a clear picture (understanding) in my head.

Well there it is, hope to hear back soon!

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4. ### Simon HampelCo-founderStaff Member

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Before you go any further - I think we need to clarify one point ...

... you are considering borrowing money and paying 8.2%pa interest and using that to invest in something returning 7.5%pa ? Is that correct ?

You are correct that if you borrow for investment purposes, then all of the interest on that borrowing is tax deductible. One thing I think you are missing is that the income you earn must also be declared - and you will pay tax on that (there's no free lunch here!).

So ... it doesn't matter about the tax deduction at all ... the nett effect is that you have to earn more than you pay in interest - otherwise you will be going backwards.

In other words ... paying 8.2% interest to earn 7.5% return is not a good idea.

5. ### bonkerrsActive Member

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This is where I'm not with it. My understanding is (or misunderstanding):

The 8.2% is tax deductible, in other words - no gains or loss here. It is money I pay the lender but get back from the ATO. This evens out... right?

Therefore, I pay tax on the earnings (7.5%) and the lender's interest should have no effect on the earnings because it is 100% tax deductible.

6. ### Simon HampelCo-founderStaff Member

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No - you don't get it "all" back - you don't actually "get it back" at all, the interest expense is offset against your income. At best, you will get a benefit of no more than 47.5% on the money you have spent (assuming you are in the top tax bracket ... if you are in a lower bracket, the benefit is correspondingly less).

Time to do some real-life sums for you.

1. borrow \$25,000 @ 8.2% interest

2. annual interest cost is \$2,050 (assuming it is charged monthly and you pay it monthly - ie no compounding)

3. invest money at 7.5% return (let's assume monthly compounding)

4. annual return = approx \$1,940 income

5. you earn \$50,000 per annum salary before tax with no other expenses or income (tax already taken out from your pay = \$9,600 plus medicare levy ... which we will ignore)

6. income from investment is added to your before-tax salary income = \$51,940 gross income before tax

7. expenses from investment activity is deducted from your gross income = \$51940 - \$2050 = \$49,890 nett income before tax

8. tax owing on nett income of \$49,980 = \$3,600 + (0.30 * 19,980) = \$3600 + \$5967 = \$9,567 (again ignoring medicare levy)

10. tax already paid = \$9,600

11. tax refund due at tax time = \$33

12. total return on investment = income - expense - tax = \$1940 - 2050 + 33 = -77

... so after tax, you've effectively lost \$77 on your investment.

Does that make more sense ?

If you earn more so you are in a higher tax bracket, your loss on the investment will be less (but still a loss). If you are in a lower tax bracket, your loss will actually be higher !!

7. ### Rob G.Well-Known Member

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7.5% per month is not a bad return !!!

Cheers,

Rob

8. ### bonkerrsActive Member

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Thanks for the great reply Sim. With the example you gave it's starting to come together for me. I will reply again later or tomorrow after I chew on this for a while and I'll do a couple of scenarios based on your reply (helps with the learning process... slow huh?!).

Rob. Absolutely! 7.5% is a great rate. This is offered by Westpac, it's a product called 'Maxi Saver'. You get 6.5% but if you don't withdrawal within a month you get a bonus rate of 7.5%.

9. ### bonkerrsActive Member

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OK, looks like I had more time tonight then I thought.

Sim, I'm working through your example each step at a time. When I'm OK with it all I'll do a scenario with a higher income and lower income, also with a higher invested amount. In your example, there are a couple of things that's doing my head in....

I'm getting \$1,875, trying to figure out where you got \$1,940?!

I'm lost here. Where did these numbers come from (I got where \$49,980 is from)

10. ### voigtstrWell-Known Member

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I think you mean 7.5% per year.
(calculated daily, paid monthly?)

11. ### Rob G.Well-Known Member

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I was joking !

It should take about 10 years at 7.5% pa.

Seriously though, you cannot expect to be regarded as a 'commercial' investment when your borrowings exceed your interest for the foreseeable future.

Where there is no prospect of ever returning a profit, the ATO *might* disallow deductions in excess of your income - arguing it is not a serious investment in order to earn assessable income.

Even if you are allowed full deductions, you are still out of pocket and the banks have benefitted by charging more than they pay out.

At least with other negative geared investments, you expect an unrealised capital gain to exceed you revenue losses.

Cheers,

Rob

12. ### Simon HampelCo-founderStaff Member

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I assumed monthly compounding interest ... so at the end of month 1 you have earned \$25,000 * (7.5% / 12) = \$156.25, at the end of month 2 you earn \$25,156.25 * (7.5% / 12) = \$157.23, at the end of month 3 you earn \$25,313.48 * (7.5% / 12) = \$158.21 ... etc.

Your figure of \$1,875 was based on an annual "simple interest" return of \$25,000 * 7.5% ... mine had interest compounding monthly.

The tax owing was straight from the ATO: Individual income tax rates

(2007-08 figures) ... \$30,001 – \$75,000 bracket tax paid is \$3,600 + 30c per \$1 over \$30,000 ... so \$3,600 + ((\$49,980 - \$30,000) * 0.30) = \$3,600 + (\$19,980 * 0.30) ... etc

13. ### bonkerrsActive Member

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This was something we were looking into at work, for work but I started to think about something similar for myself.

Thanks again Sim for your explaination. I should have realised this was too good!