This one’s an action packed episode! Louis Strange and Jayden Vecchio are going to take you through how to set up your property portfolio correctly and their top five tips on what might sound simple, but are so critical when it comes to building a portfolio. Here are our sweet loan structuring tips for Rentvestors.
Here are our sweet loan structuring tips for current and future Rentvestors.
#Tip 1: Don’t be a principal and interest (P&I) noob (Investment-specific)
When you get a home loan, there are a few options. You can either go principal and interest repayments or you can go interest only. There are some pros and cons for each strategy but for investments, interest only is usually the best option.
When it comes to investment properties, you’ve only got one opportunity to crystallise the maximum tax deductible loan amount, which is when you borrow it. Those funds are used for the purpose – to purchase an investment property.
Example:
If you bought a property, then in five years time you would like to increase your loan, it’s too late. If your purpose then is to pull the funds out for another purpose, it’s no longer tax deductible and that causes issues.
When the ATO looks at what is “tax deductible”, they ask: what is the purpose and does it generate an income? So if you’re buying a block of land as an investment, unless you have tents set up or a carpark you’re renting out, it won’t be earning you an income, so whatever debt you’ve taken out against a property is not tax deductible.
If you’re on principal and interest repayments, the repayments will be higher. The principal repayments – what you’re making back is not deductible. So it works out that you’re destroying deductibility and your cash flow looks worse for wear.
Solution – Using an offset account!
When you’ve got a loan, you’ve got access to redraw. So for example, if you have a credit card and you take money out, you owe $5,000. You then put $5,000 in, so net-net you’re 0.
Redraw is the same with a home loan. If you owe $500k and put $5,000 at redraw, you only owe $495k but if you try and pull that $5,000 out at a later date it affects your deductibility capacity. Because then the purpose for the $5,000 coming out is for something different.
So the magic of an offset account is that it works like a bank account but it’s attached to your home loan. Similar to a redraw but it doesn’t have that negative consequence when you take funds back out.
Rentvesting tip: The funds are portioned not to be deductible with a redraw, but with an offset account for the same example: $500k with an offset account and you put $5,000 in that bank account. It reduces the effective loan (what you’re paying interest on) it goes to $495k, as soon as you take that $5000 back out it doesn’t destroy the deductibility. Your loan goes back to $500k and the interest you repay on that is still deductible.
Tip #2: Don’t speculate on interest rates!
Should I fix or go variable?
Why go variable?
- It’s much more flexible, you can make extra repayments and get an offset account.
- You can sell and it gives you flexibility. There are no restrictions, you can move and refinance – it’s easy.
Why fix rates (pros and cons)?
- It gives you certainty when it comes to making repayments. If you know your rates are fixed, you know your repayments won’t go down or up. Whereas variables could change depending on the RBA cash rate.
- The negative is that you can’t make additional repayments. The banks usually put limitations on making extra/accelerated repayments. So if you’re paying fixed repayments of $4,000 a month, you won’t be able to make accelerated payments (like $6,000 a month).
- You won’t get an offset account and if you do, its only partial offset.
- If you want to refinance or sell, there are breaking costs on the fixed interest rate. It’s really bad if interest rates go down after you fix because you can’t re-fix.
For example:
During the GFC we had a client who fixed their rates at 9% for 5 years. Overnight, the RBA cut rates from 9% down by 1-2%. Interest rates went down to 6% in a short span of time. This poor guy was stuck paying 9% for 5 years. We did a fixed rate cost calculation and his costs were going to be over $50k to exit these fees – as they were big chunky loans. The point is, no one knows what the future holds so there’s no point speculating. Fix rates are really only good if you want to lock in your yields or travel.
The negative is if interest rates do go up with variables, then you’re paying more. Typically when you look at long-term fixed rates that the banks are offering, like a 5-year fix rate, they already know the level of what’s going to make them more money over the long term.
On the ASX website, you can look at the fancy ‘futures’ and what the expectations of the market are. As far as movements on the interest rates, there was an expectation that they’d drop, but now it’s really flat and looks like it’s moving up. The thing is, if you fix an interest rate now, it’s going to be at a higher rate because the banks know that the rates have a higher chance of going up.
Really, it all depends on your situation, but it’s something to think about before jumping into fix rates.
Tip #3: Sweet strategies to bullet debt
If it’s owner occupied or an investment that is cash flow positive, debt can stifle cash flow so you want to get rid of it ASAP.
For owner occupied and principal and interest specific, there are a few little things you can do to reduce your overall interest paid.
The way the bank figures out the monthly interest you have to pay is calculated on a daily basis. So when you look at fortnightly repayments over monthly repayments – fortnightly you get two extra repayments in the month, which means you pay less interest overall by making more repayments.
Rentvesting tip: The difference between fortnightly and monthly repayments can cut the term down by 2 – 3 years. It has nothing to do with you making additional payments, it’s just about changing the frequency of repayments.
Tip #4: Loyalty doesn’t pay
Staying with one bank might seem like a good idea but there are always new deals and the lending market is very fluid, which means that you can move around very easily.
Different banks have different policies depending on your income and whether you’re permanent or casual. They also have different valuers, which means that the difference between valuers can be up to $50k – $60k, so it is worth shopping around.
They also get lazy and make their money from lazy customers who don’t know there are better deals out there.
Apathy is the biggest thing banks rely on. If they know you have three or more products with them (like home loan, credit card, investments, insurance) it’s around a 95% retention rate regardless of what happens. This is due to the fact people don’t want to have to change their accounts.
Rentvesting tip: Between the big banks, they’re trying to fight for market share. But really, they don’t have to do much when there are only four big players. Therefore, loyalty doesn’t pay.
Tip #5: The most important tip: Never cross securitise.
Cross securitisation (or cross collatoralisation) is when you have an existing property, like a house worth $X then you buy another one and put both properties together then lend against the amalgamated security. However, when you go to sell, it’s very hard.
It comes back to the valuation point where if you’re going to sell one property and its cross securitised, they will request you value both. If GFC were to happen again and both properties go down in value, they’ll take the total combined loan with total combined value.
Rentvesting tip: If you’ve got a property in Moranbah and a property in Sydney, if they’re cross securitised, they will merge together and it will devalue your Sydney property. Overall, it leaves less control in your hands and more in the banks. Don’t do it!
In summary
- Don’t be a P&I noob, go interest only if it’s an investment.
- Don’t speculate on the rate. If you are really worried you can do both, get a large variable account and a small fixed account. In the long term, variable does average out to be flexible and can save you money because you can get out of it.
- Debt – fortnightly or weekly repayments will make a huge difference to your interest. If you’ve got any extra repayments you can put in for owner occupied, which can knock off a lot of long term interest.
- Loyalty doesn’t pay! You miss out on different policies and banks get lazy.
- Don’t cross securitise. Stay in control and don’t bend over backwards for the banks. Unless you’re 100% certain, always talk to a broker first and they will be able to advise you.
The Rentvesting Podcast, available on iTunes, was created by Red & Co’s Jayden Vecchio and expert financial planner Louis Strange. Together, Jayden and Louis unpack the facts behind the property market, explain what’s really going on & where the market is heading. They believe in challenging the status quo and want to get out there to educate absolutely anyone looking to enter the property market.
