Very few people acquire financial independence without a large investment in time and energy. It is foolhardy to think that reward will follow little effort. The market owes you nothing just for trying.
Investing in property is not the path to easy riches that many would have you think. You have to source the funds, structure the lending in the most advantageous way and ensure you have the cash flow to persist with the investment. The question then becomes – are you in control of your investments or are they controlling you? At Moneybright we can ensure that you maximise the probability of retaining control right from the start and not let the tail wag the dog.
Buying a property to rent out is a popular form of investment. Houses and units are easier to understand than many other types of investments, yet they do have some issues you need to be aware of.
First of all, you need to locate the right property. You will want somewhere where tenants are easy to find and don’t forget to diversify across locations as well.
Do You Have The Capacity?
Most people use equity from their home to help buy their first investment property. Then you can use the equity from both your home and investment property to buy your next property. This makes owning a portfolio of properties easier over time without the need to save up for a deposit.
Equity is the amount of money in your home that you actually own. It can be calculated by working out the difference between what your property is worth and what you owe on the mortgage. For example, if your home is currently worth $600,000, and you have $250,000 remaining to pay off on the mortgage, you have $350,000 worth of equity.
Also, using the equity in your existing home can allow you to borrow the full value of the investment property with an interest-only loan.
Lender’s Mortgage Insurance
Most investors try to avoid paying LMI, as it can be very costly. As an investor you can access up to 80% of your home equity. This may cover part, or all, of that deposit amount.
However, others investors are quite happy to pay LMI because it means they take less equity out of their home or it gives them the scope to buy multiple properties. That is, they can buy two investment properties with a 10 per cent deposit rather than one with a 20 per cent deposit. This strategy, while costing more has the advantage of allowing a faster accumulation of a property portfolio. So it really depends on what your focus is.
Cross Securitisation or Collateralisation
Most investors are generally keen to avoid putting up their family home as security for their investment property. Cross collateralisation occurs when two or more properties are used to secure one or more loans by the same lender.
In contrast, having the properties ‘stand alone’ provides a greater level of asset protection if something were to happen to the investment property or if it drastically fell in value. If you do need to cross-collateralise, it is preferable to use the family home as the secondary rather than primary security.
Standard bank practice involves placing the property with the highest value as the primary security.
Which Loan Product?
Interest on an investment property loan is generally tax deductible, but some borrowing costs are not immediately deductible and knowing the difference can count. Structuring your loan correctly is critical.
It is best to avoid mixing up investment property loans with your home loan. Ideally they need to be separate so you can maximise your ongoing taxation benefits and reduce your accounting costs.
Fixed or Variable
It really depends on circumstances but consider both options carefully before you decide.
Over time variable rates have proven to be cheaper, but selecting a fixed rate loan at the right time can really pay off. Rates will tend to rise when an economy is doing well, so increasing interest rates are not always bad news for property investors. This is because one would expect rising property prices when the economy is doing well.
Most investment loans should be set up as interest only as this increases the tax effectiveness of your investment, particularly if you have a home loan.
The reason interest only loans work well for investment properties, is that a principal and Interest loan reduces the negative gearing benefit as you pay down the amount of your loan. Consideration should also be given to an investment loan that gives you the opportunity of paying interest in advance or has an offset account.
Line of Credit (LOC)
When purchasing a home, most people pay a deposit and then take out a loan or a mortgage for the remainder. This means that most people start out with at least a small amount of equity in their home. Ideally the property’s value will increase over time. Combined with regular mortgage payments the equity in the house will increase.
A line of credit equity loan allows a homeowner to receive a line of credit up to the current equity in the house. In most situations, the credit limit is set at 80% of the value of the property. So if you had $300,000 equity in a $500,000 property, the line of credit would likely be $200,000 (LOC = [80% of value] minus debt).
The borrower can access the money at any time, without having to apply for it. Access will be via a special cheque, card or dedicated internet banking accounts. The borrower can take out as much or as little money as they choose, as long as it doesn’t go over the limit.
Once money has been drawn down from the line of credit equity loan interest repayments are required on that amount – not the line of credit limit unused. If a borrower decides to make repayments, it can be added to the line of credit. For example, if a borrower takes $80,000 from their line of credit for a deposit and they pay back $1000 a month, the repayment can be drawn from the line of credit so that the amount drawn down is now $81,000 (as long as the credit limit is not exceeded). However, equity is being depleted in this case.
Paying For It
1. Beware of the Following
While you could argue the most important consideration of whether to purchase an investment property should be the yield it offers, many investors are happy to overlook that to some degree with the hope of future capital gains. This can be risky because in the interim:
- rental income may not cover your mortgage payments or other expenses so you may have to use other money to cover these costs
- an increase in interest rates will increase your repayments and decrease your disposable income
- there may be periods of time where you don’t have a tenant and will have to cover all costs yourself
2. Negative Gearing
The first point above refers to negative gearing. This means you pay money towards the property each year because the total cost of the property is more than the total income of the property. The advantage is that the loss can be used to reduce the amount of tax due on your other earnings. Remember, you are only reducing your tax payable because the income from your investment isn’t covering your expenses.
3. Positive Gearing
In contrast, positive gearing means you make money from the property each year (total income is more than the total cost). That is after taking into account all costs associated with the property (such as borrowing and maintenance costs), and all income including tax breaks. Not knowing how much a property is going to cost you per week before you buy is a big mistake. Being forced to sell at an inopportune time because of cash flow issues could be a more unfortunate mistake.
4. Line of Credit and Cash Flow
As mentioned above, a line of credit (LOC) is like a big credit card. You have a pre-approved credit limit you can draw funds out up to.
Say there is a $700 a month difference between the income your investment property is earning and the expenses that you incur. For most people that is a significant amount of money to find each month.
You could consider using equity in another property to establish a line of credit as a ‘working account’. For example, a line of credit of $30,000 could be established. Then all the property’s income and expenses can be run through the account and the $700 monthly shortfall is funded from the $30,000.
The investor has the option to only fund the interest on the line of credit at a minimum, which in this example would be only about $38 a month and is also tax deductible. However, it is important to note that the downside to this strategy is that you are eating up some of the equity in your own property. So you need to be confident that your investment property will have good capital growth.