(03) 9020 2905Bruce Brammall, The Australian, 24 October, 2021
My dad gave me a foolproof rule to never lock my keys in my car. Always lock your car from the outside, with the keys.
Simple, but unbeatable. And it saved me from ever locking my keys in the car. Except for once.
The morning we bought our first home.
I was so nervous. I don’t know why, but I locked the car the other way – pushing the lock button down and holding the handle up as you close the door. With the keys safely in the ignition. (Those under 25 probably won’t even know what I’m talking about.)
Buying property is nerve-wracking. You’re agreeing to what seems like a lifetime of debt, whether home or investment.
Investment property is a debt strategy. You’re agreeing to service a pile of debt in the expectation/hope the asset will rise much faster in value than the net costs.
The biggest cost, by miles, of an investment property is the interest bill. And getting the debt part of the strategy is, therefore, critical.
There are many innocent – but horrible and expensive – mistakes investors, particularly first-time investors, can make.
Getting it wrong can cost you thousands of dollars a year, which can compound over time.
I love investment property. Good investment property can be an awesome long-term wealth creation strategy. (Bad investment property can be utterly ruinous.)
Get the debt part of the equation right. If you just roll up to a bank and ask them to fund your purchase, you’re just going to be sold debt.
But particularly when you’re talking multiple properties, the structure of your debt and cashflow is critical. If you don’t know what you’re doing, get advice. (And don’t treat the following as personal advice, as I don’t know your individual circumstances.)
HOMEOWNERS – USE EQUITY
The most common path to buy investment property is years after you’ve bought your first home.
You’ve developed some home equity. You’ve built up some savings in the offset/redraw account. You’re ready to buy an investment.
There is a huge landmine waiting right here, ready to blow you to bits.
“Honey, let’s use some of the savings in our offset account, so we can keep the new investment property loan down a bit. It won’t feel as big then,” says Pumpkin to Honey Bunny.
BOOM! Cash confetti, all over the loungeroom. Pumpkin just blew up thousands of dollars right there.
If you still have a home loan, that’s the loan you pay down. Not the investment loan.
First, home is not a tax deduction, but your investment loan will be.
Let’s say you have a spare $100,000 in savings. It will almost always make more sense to have that cash on the home loan instead of the investment.
Your home loan is $300,000 and the investment property you wish to purchase is $600,000. With $100,000 in savings, you could either pay your home loan down to $200,000, or only borrow $500,000 for investment.
Pay down the home loan. Tax-deductible property debt is generally cheaper, even with a higher interest rate, than home loan debt.
How? If $100,000 of extra debt was at home loan rates, the rate would be about 2.5 per cent and it would cost $2500 a year. If it was investment debt, the interest rate might be 3.2 per cent (or $3200 a year), but after getting a tax deduction on the $3200, the net cost would be $2096 (with a marginal tax rate of 34.5 per cent) or $1952 (39 per cent marginal tax rate) or even less for very high income earners.
TAKING IT A STEP FURTHER
So, wouldn’t you always borrow the maximum for investment and minimise home loan debt?
Yes, generally. By structuring the loans properly, you can borrow 105 per cent of the value of the property. You put 80 per cent against the investment property itself and the other 25 per cent (including stamp duties) against your own home, assuming you have enough equity.
You’re just splitting the debt across two properties. It will all still be tax-deductible, because the ATO looks at the “purpose of the loan”.
RENTVESTERS – STASH YOUR CASH
It’s a slightly different scenario for “rentvesters”. Those buying their first investment property, while still renting, don’t have property equity they can lean on.
But even rentvesters with a bigger deposit for an investment property shouldn’t necessarily tip it all in to keep the loan down.
If an investment property is your first property purchase, you’ll have to put some savings into the deal. Banks won’t lend the entire purchase price plus costs without other bricks and mortar security.
For some, it will make more sense to put in as little of your savings as you can. (If you do have leftover savings, it can go into an offset account to save you interest.)
In most cases, this will mean borrowing 90 per cent of the value of the property and only tipping in 10 per cent, plus stamp duty, yourself.
Two good reasons. First, you can keep any extra savings aside for buying your own first home (or other investing) and second, you’ll maintain higher tax deductions.
The obvious downside, however, is paying “lenders mortgage insurance” if you borrow more than 80 per cent of the value of the property.
DON’T RISK YOUR HOME
A concern with walking into your local lender is the potential for “cross-collateralisation”. This means a lender is taking multiple properties to provide security for your loans.
Lenders sometimes do this to maximise their security. If you fail on your loan, they can sell both the investment and your home to repay the debt.
As outlined above, you give yourself more security by splitting the investment loans in two and placing over two properties. If your fall into trouble, this can add extra options for you.
Some lenders will sell this as “simpler”.
Cross-collateralising property is not all evil behaviour. But never accept “it’s easier/simpler” as the reason. It’s easier/simpler for the lender in the event that something goes wrong at your end. But if that happens, it could compound your nightmare.
INTEREST ONLY?
As a general rule, if you’ve only got one property, stick with principal and interest. If you’ve got two, make the investment interest only.
While interest-only on an investment loan is likely to come with a slightly higher interest rate, it will allow you to concentrate on paying down your home loan faster.
HOME TO INVESTMENT
Common errors occur when people want to upgrade or downgrade, but keep their home as an investment.
It’s usually sentimental reasons. But it lacks even the most basic of financial common sense.
There are four main reasons you should generally sell one home when you move onto the next.
One: In most cases, selling a home is capital gains tax free. But once a property becomes an investment, it may incur CGT when sold later.
Two: You probably should, or need to, take the equity with you. Where are you going to get the money to buy Home #2? Without taking the equity with you, the loan is going to be, pretty much, the whole amount.
Three: If Home #1 is worth $800,000, with a loan of $200,000 left on it, then you only have tax deductibility for $200,000. Sure, you can borrow against that property to buy Home #2, but none of those new borrowings will be tax deductible.
Four: If you want an investment property, it will make far more financial sense to sell the home, take the $600,000 of equity to keep your home loan at $600,000 on Home #2 and then buy another investment property.
Then you can gear the new property fully and maximise the tax-deductible portion of your loans.
The real cost of doing this is the cost of selling your former home and stamp duties to buy the new investment property.
By listening to a pro (my Dad), I only stuffed up with the keys in my car once. But the consequence of that was insignificant.
Stuffing up lending for purchases worth hundreds of thousands of dollars is expensive. If you don’t know what you’re doing, don’t risk it. Get advice.
Bruce Brammall is both a financial adviser and mortgage broker and author of books including Mortgages Made Easy. E: bruce@brucebrammallfinancial.com.au.