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The new rules of finance can catch your unawares

Apr 18, 2018

We have known for a long time that most home owners are not aware of their interest rate.  In fact a staggering 85% of borrowers are unaware of their interest rate (1).

However the cost of fixed interest rates have recently began increasing for interest only loans compared to loan that repay principal and interest.  In some cases we have seen a staggering 1% premium or more for interest only loans.

How does this help?

Well an interest only loan is just that.  You will only ever repay the interest cost and you will not repay the actual capital of the loan.

This can be a good strategy.  It allows you to access more investments with a limited cashflow.  And many people with an interest only loan will go ahead on the grounds that they will eventually sell the asset to repay the debt.

If you are an interest only payer then you could look into converting the loan to a principal and interest loan and increasing the monthly cost by ending up clearing your debt.  The reduced cost of interest will partially reduce the increased loan repayments.

For example

John buys a rental property in Mullaloo for $850k.  It generates a net rent (after agents costs, rates, repairs etc) of $1,800 a month.

John borrows $850k from the bank on an interest only loan.  He is not fully aware of the interest rate and ends up paying the bank an interest rate of 5.3% so the monthly interest cost is $3,754.

In this case John incurs a net loss on owning the investment of $1,954 a month.

However if John borrows the same amount of money with a principal and interest loan his interest rate might become 3.99%.  However the loan will also require the capital to be repaid.  So the principal and capital is now $4,053 a month.

The property now costs $2,253 a month (compared to $1,954).  However the loan will be repaid in full in 30 years time.

Now the after tax cost will work out differently as the interest cost is most likely tax deductible.  And the property might generate additional tax deductions by virtue of the building depreciation and the depreciation on fittings – so the next after tax cost can only be done by a tax professional who is licensed to do these type of calculations.

Real life is different

Most property investors in Perth do not really want a principal and interest loan.  The primary benefit of an interest only loan is that it frees up cash flow to do other investments.

Alternatively they might have a lot of debt with no interest payable.  And if they do waste precious capital on repaying debt they will not enjoy a tax deduction for the repayment.

For example

Rupert is a wealthy retired property developer.  He owns a property portfolio worth $56m.

Rupert also has loans on the portfolio of $24m.  This was the original purchase price of his properties.

Rupert has cash in offsets of $24m.  So he does not incur a cent in interest cost to the banks.

In this case the conversion of an interest only loan to a principal and interest loan is not worthwhile.  The investor (Rupert) is not paying interest anyway – and the reduction in the loan limit will simply reduce future flexibility.

As a side issue: if Rupert takes from the offsets (to eat food or the like) the interest will probably become tax deductible.

So a property investor will look at a combination of interest only and principal and interest loans.  Ideally the portion of a loan that is offset by cash holdings will remain as an interest only loan.  And the portion of the loan that is incurring interest can be converted to a principal and interest loan to give the benefit of the lower interest rate.

Importantly the after tax cash modelling of the loan structures should only be done by a licensed tax professional (a registered tax agent or a lawyer) as the tax deductibility of the interest cost is the primary point of note for many investors.

Getting clarity on what is going on

If you have clarity on understanding the benefit of mixing the interest only and principal and interest portions up you should then compare that position to your loan serviceability.

Sometimes the concept of paying down debt is great but if you can’t afford to service your current debts now you are unlikely to be able to service them with principal reductions (and noting the principal reductions are not tax deductible).

Dealing with a few banks so you are not limited to one lenders decisions is also important.  We have a few families whose bank, during the GFC, simply decided to exit the home loan market.  And this made their position difficult.

Talking to the bank

A lot of clients are noting that their interest only review periods are coming up.  And it is important to understand your loan positions and the cash flow impact of your loan modelling prior to understanding this.  Effectively you want to get in front of the bank.

At Westcourt we do a lot of financial modelling for property investors.  This will typically include “what is analysis” between the modelling for an interest only position (after tax) and principal and interest.  If you then consider the ability to stop cross-collateralising your debts across your property portfolio you can not only pre-empt bank pressure you can also capitalise on the benefits of different loan positions across banks – while restricting your security exposure.

As a guide the cost of a financial model for three properties, which will give a detailed, after tax report of somewhere from 35 to 80 pages of results, together with a partner level consult, will cost somebody around $1,650 including GST which is tax deductible.

Regardless of how you are approaching the matter you should focus on the after tax cost of a strategy.  So getting a tax professional at some stage to give written advice is critical.  If your professional advisor is not giving tax advice you are running the risk of doubling the cost of your interest.

* UBank Know Your Numbers Index data conducted and compiled by Galaxy Research of 1,015 Australians in February 2018.

 

 



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