Strategies
What is negative gearing. What is positive cash flow. Discover our mortgage reduction strategy unique to dual occupancy property in Perth.
Dual Key Strategies
Negative Gearing simply means borrowing money to buy an asset. In the case of property, you have taken out a loan to purchase a property, such as dual key house and land packages.
Negative gearing means that the interest you are paying on the loan is more than the income. As a result, you are making a loss.
So, if negative gearing means that you’re making a loss, why is that a positive?
Obviously, nobody wants to get into property investment to lose money. Even though most property that you will buy, including dual key house and land packages, will be negatively geared—that is, the rental income is not as much as the interest repayment—the benefit comes from the capital growth. Let’s look at the example below to clarify this point. There are other expenses related to owning property, but I will keep this example simple and focus on the interest expenses.
Let’s imagine you bought a $500,000 property and took out a $450,000 loan at an interest rate of 4.95%. The annual interest payable on the loan is $22,275, rates would be $2500, insurance $800 and property management $2,275.
Let’s also imagine that you are earning $450 per week in rent, which adds up to an annual rental income of $23,400.
Based on the above example, you are paying $27,850 in interest and costs but only earning $23,400 in rent which means there is a shortfall of $4,450 per year. That’s the bad news.
The good news is that the property should be going up in value and it is worth more as time goes on. If the property went up in value by 8% in that year, it has increased its value by $40,000.
At the end of one year, you have paid out $4,450 in interest but the property has increased in value by $40,000 which means that you are $35,550 richer than you were 12 months ago.
To clarify your own cash flow position don’t forget to include all the other property related expenses and any tax return income. In summary, negative gearing works IF the money you make from the capital growth is greater than the loss you make in rental shortfall.
It would be great to be neutrally or even positively geared and still make a net profit but these sorts of properties have been hard to find... until now.
Positive Cash Flow
The term positive gearing is also thrown around quite a bit in the world of property investing. Put simply, positive gearing means that the income (rent) the property receives is greater than the cost of holding the investment property
So, positive gearing means that you’re making a profit?
Everyone wants to get into property investment to make money. Positive Cash Flow property that you will buy will be positively geared, that is the rental income is more than interest repayments and holding costs, plus the benefit from the capital growth.
Let’s look at the example below to clarify this point.
Let’s imagine you bought a $500,000 property and took out a $450,000 loan at an interest rate of 4.95%. The annual interest payable on the loan is $22,275, rates would be $2,500, insurance $800 and property management $4,160.
Let’s also imagine that you are earning $800 per week in rent, which adds up to an annual rental income of $41,600.
Based on the above example, you are paying $29,735 in interest and costs but earning $41,600 in rent which means there is surplus income of $11,865 per year. That’s not the only good news.
The extra good news is that the property should be going up in value and it is worth more as time goes on. If the property went up in value by 8% in that year, it has increased its value by $40,000.
At the end of one year, you have $11,865 surplus income but the property has also increased in value by $40,000 which means that you are $51,865 wealthier than you were 12 months ago.
Mortgage Reduction
HOW DOES THE MORTGAGE REDUCTION STRATEGY WORK?
Many clients adopt a conventional approach to investing — paying off their Mortgage before buying an investment property. However, this approach largely ignores tax efficiency, which is where the strategy of mortgage reduction can come into its own.
The mortgage reduction strategy is a wealth accumulation strategy. It is about purchasing a Positive Cash Flow investment property now rather than investing later.
By investing now you convert inefficient non-deductible debt (your mortgage) to efficient deductible debt( loan on your new investment property). That's what the strategy is all about; getting more tax efficiency with your debt.
With non-deductible debt, the interest payments on a home loan are paid from after-tax dollars. In addition, the interest payments are not tax deductible. However, deductible debt is investment debt used to buy assets that generate taxable income, therefore the interest payments are generally fully tax-deductible. The mortgage reduction strategy works by replacing non-deductible (inefficient or 'bad') debt with deductible (efficient or 'good') debt and investing now.
The mortgage reduction strategy works by using surplus income to reduce “bad” debt such as the home mortgage, and in doing so, the equity in the investment is generally increased.
This is further explained in the following four steps:
1. You direct all surplus income into the home mortgage.
2. At the end of the financial year, you borrow back the increased equity via a separately identifiable investment loan and invest in growth assets such as shares, property or managed funds.
3. Earnings from the investment portfolio are directed into the home mortgage to reduce the outstanding debt (in addition to other surplus income).
4. At the end of the next financial year, the client borrows back the increased home equity via the investment loan and purchases additional investments. The process can be continued until the mortgage is repaid, and the entire debt is essentially converted into tax-deductible debt. Once all nondeductible debt is repaid, surplus income, including investment income and tax savings, can be used to buy more investments or to pay down the investment loan.
Once clearly identified, any income and tax savings or other income derived from the investment can be used to reduce the existing non-deductible home loan.