Tag Archives: Net Income

Investing, Renting

Gearing: understanding the buzzword

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Gearing relates to how you structure the financial position on an investment property (or any income producing asset). You can be positively, neutral or negatively geared.

I have a friend who has some big ideas on property, some of which are great and others I question whether he is regurgitating buzzwords without necessarily understanding what they mean. My friend wants to buy an investment property and negatively gear it, but what he hasn’t considered is that negative gearing requires a cash outflow on his part, and when he isn’t in a surplus cash position to start with this could be a financial burden. “Negative Gearing” is a big tax buzzword but for most normal people it can live up to it’s name and just be… negative.

Negative Gearing

Negative gearing is where expenses outweigh income. For example, you own an apartment with a mortgage that you rent out. Typical expenses would be, for example:

$    1,200 / mth mortgage payments (assume interest only)

$     800 / qtr strata fees

$    1,000 / yr council rates and water bills

$     500 / yr occasional repairs and maintenance

$     300 / yr rental agency fees

$19,400 annual expenses

You receive rent of $350 per week, which is $18,200 of annual income. Therefore the property costs you a loss of $1,200 per year. This means you have to spend $1,200 of your own cash each year on this property.

There are two main reasons why people chose to negatively gear:

  1. They are high-income earners who are looking for a tax deduction. The cash outlay of $1,200 will be used to offset against their income to lower their tax obligations. For the highest earning tax bracket this means they will receive a credit against their tax of $588 but the net effect is they still need to outlay $612 cash against the property. Great for someone who has lots of cash.
  1. They are hoping that the capital gain on the property will outweigh the costs of negatively gearing it. For instance, the apartment cost you $380k to buy and if you sell in three years time for $430k, less stamp duty, selling agency fees etc you have made a gain of approx $20k, of which you can keep just over half after paying your tax bill, which means for $1,836 cash outlay, you have made a net gain of $8,164 (which is not a great return, but that’s for another post!).

All good reasons to negatively gear, but if you don’t have surplus cash, are not on a high tax rate and/or expect some capital growth in the property regardless, negative gearing might not be for you.

Neutral Gearing

This is where you manage the expenses and income of the property to effectively net out to zero.

I have chosen this option in the past because I wanted my investment property to just “pay for itself” while it grew in value.

Positive Gearing

This is where you want to earn an income from your property. Great if you don’t earn a salary, i.e. you’re a non-working parent, or you are retired and are living off your assets.

This is where the rental income on the property is greater than the expenses. You may pay tax on the net income earned (depending on your overall tax position), but you will be receiving income and therefore a cash inflow.

Before I went on maternity leave I prepaid a year of mortgage repayments on the investment loan on my mortgage to bring forward greater expenses in the year I was still earning a wage (i.e. the property was negatively geared in that year). The year I wasn’t earning an income while on maternity leave my property was positively geared, which provided a small but helpful income. So you can change your gearing depending on your situation.

So please don’t get caught up in buzzwords like “negative gearing” without fully understanding what they mean to you. If anyone has any other buzzwords they would like clarification on, please include in the comments below…

Buying, Financing, Renovating, Renting

Will this property be a home or an investment, now and in the future?

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This is the fourth and final post in my introduction to personal property finance series. A very clever friend of mine commented on a previous post when discussing fixed v variable mortgages, that you can have a number of fixed mortgages. For instance, if you’d decided to fix $150k of your mortgage, you could get 3 x $50k fixed mortgages, which would allow you to repay more principal. Many financial providers restrict the amount of principal you can repay on a mortgage. So if the limit was $10k for mortgage, if you had three fixed mortgages, you could repay $30k of your total $150k fixed mortgage. Splitting your mortgages could also provide more flexibility if you wanted to fix some for one year, some for two years, and so on.

However… this is if you want to repay principal. Many people falsely assume you have to repay your mortgage and that repayments have to include principal and interest (P&I).

Now you’re probably thinking… but then I am not paying down my mortgage and I’m not “getting ahead”, or why would I want to pay the bank all of that interest?, or I thought those sort of mortgages were only for investors… Let me answer all of your concerns and show you that having an Interest Only loan is the best option for you.

First and foremost, your monthly repayments on a P&I mortgage will be higher than Interest Only. On a $100k mortgage where the interest rate if 4.69% and term is 25 years, your P&I repayment is $566.67 (P $175.84 & I $390.83). On the same mortgage, your interest only payment is $390.83. You save $175.84 a month!! When calculating how much you can repay (see previous post “What mortgage payments can I comfortably afford?”), an interest only loan may mean you could comfortably borrow more.

Secondly, if you have an offset account you don’t need to repay principal. See my previous post “What is my risk appetite regarding fixed versus variable mortgages?” for an explanation of offset accounts. If I have a $100k mortgage and $20k in savings in my offset account, this means I only pay interest on $80k. My monthly payments are even less $312.67, and my principal has been reduced by $20k. With a P&I mortgage, I am out of pocket $566.67 in the same month, and I have only repaid $175.84 of principal!! It would take almost 8 years to repay $20k via P&I repayments.

While you are not technically “repaying principal” or “paying off your mortgage” with an interest only mortgage with an offset account, you are reducing the principal amount of the loan, and therefore paying less in repayments.

So maybe you think… well that’s fine but I don’t have a spare $20k to stick in an offset account… even if you only have $1k in your offset and you deposit some small savings each month, you are a lot better off than trying to pay P&I. The more savings you deposit in your offset, the lower your mortgage payments are (incentive!) and you will pay less and less interest to the bank.

The big seller for me on an interest only mortgage with an offset account is the savings you deposit to reduce your principal is YOUR MONEY. You can do with it what you like, you can take it out when you want, and you can put more or less in each month. You can deposit $20k in your offset account and decide a few months later you want to renovate your bathroom. In the meantime you have reduced your monthly payments dramatically AND still have access to YOUR money. If you are repaying P&I, you cannot withdraw that $175.84 of principal. In time you can draw down equity on your home but that is a much more complicated process than transferring some funds from one account to another in your internet banking and hey presto! you’ve got $20k to spend on your renovations.

And finally, the question some people don’t ask themselves when buying a property is… “will I ever rent out this property” …what happens if work posts you interstate, a relative gets sick and you move to care for them, or even that you are lucky enough to buy another property to move into without having to sell the current one… your property could end up being an investment and rented out. If there is any chance this is a possibility, you should strongly consider an Interest Only mortgage as only the interest portion of your mortgage payments will be tax deductible. This leads us into a bigger discussion with regards to “gearing”, which I will cover in the next post.

So really, it’s a no brainer! Interest only mortgages are cheaper, may allow you to comfortably borrow more, with an offset account offer the ability to reduce principal significantly faster than repaying principal each month, and gives you access to that principal any time you want it, all while providing the flexibility for the future with regards to renting the property out as an investment. I promise you’ll be “getting ahead” a lot faster with an Interest Only mortgage.

 

Note 1: I found a few handy mortgage payment calculators: http://www.planabettermortgage.com.au/loan-calculators/p–i–interest-only.htm or http://www.infochoice.com.au/calculators/principal-and-interest-calculator/

 

 

Note 2: There has been vigorous discussion lately from various politicians that they want to get rid of Interest Only mortgages as they think they are contributing to Australia’s property “bubble”, however these mortgages are still widely available.

Financing

#5 What mortgage payments can I comfortably afford?

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So with $100,000 we can afford to buy a $400,000 property. But can we make the mortgage payments? Looking at a home loan comparison rate finder on the internet I can see the lowest three year fixed rate home loan rate is currently 4.69% (June 2014), which would make our monthly payments $1,250.  But can we afford this?

Regardless of how much the financial provider will lend you, you need to do your own calculations to work out realistically and comfortably how much you can borrow. I remember when I was asking for mortgage pre-approval five years ago the bank was willing to lend me close to $1million!! Believe me, I could NOT have afforded this AND been able to buy bread and milk each week!

FIRSTLY you need to work out your income and expenses. The simplest way to do this is get all of your bank and credit card statements for the last 3-6 months and identify all of your (and partner’s if relevant) net income (post tax and super) and expenses. Being the geek I am I like to put this in a spreadsheet & categorise it. Remove any non-recurring items but make sure you include big annual expenses such as holidays and insurance policies and income such as bonuses. If the property will be your new home, deduct any rent or mortgage payments as these will not continue. Let’s assume we’re doing this analysis for a monthly basis.

Income:
$ 3,750           Salary (net after tax & super)
$      50           Share dividends
$    300           Interest
$ 4,100          Total Income

Expenses:
$    300           Utilities
$    350           Food (at home)
$    500           Entertainment: eating out, alcohol, movies, etc
$    150           Mobile phone, travel to work, magazines
$    400           Car payments, petrol, servicing, insurance, etc
$    300           Clothes
$    300           Holidays
$    400           Insurance: home & contents, health, etc
$    200           Personal care
$    100          Gifts
$ 3,000          Total Expenses

Net income per average month $1,100

This exercise is very simple if a bit tedious, but unbelievably eye-opening too. If you categorise your expenses and calculate the percentage of each category against the total, sometimes you might be frightened how much you spend on gifts, going out, travel etc. It’s also a good exercise to do if you want to save money.

SECONDLY you need to forecast your short to medium term financial position. Consider the timeframe that you would consider fixing the mortgage for (typically 3-5 years). This is incredibly important because if your circumstances change, you need to still be able to comfortably pay the mortgage. Some things to consider…

  • Income increasing – For example, if you have your own business and it is in the growth phase, or you expect a pay increase from work. This is a tricky one and being the conservative I am, tend to approach this type of forecasting with caution,
  • Income decreasing – For example, what are the chances of being made redundant? Is there a seasonal downturn in your earnings? Will one of you be going on maternity/paternity leave soon?,
  • Expenses increasing – For example, will I start having children, or for those parents out there, another child? Are you buying a new car? Going to start studying again?,
  • Expenses decreasing – For example, will repayment of HECS debt or any other loans or credit cards be ending soon?

Adjust your average monthly income and expenses for these future events and you end up with the net amount available to pay a mortgage. If you also want to save money in addition to paying your mortgage then adjust this further.

LASTLY, using a simple calculation we can work out the mortgage payments you can comfortably make each month:     (monthly net income X 12 mths)  /   annual mortgage rate %

In this example:                                                                                        (1,100 X 12)    /    4.69%     = $281,000 mortgage

Therefore this tells us that even though we have saved $100,000 (well done!!) and we can afford to buy a $400,000 property (with a $320,000 mortgage), we actually can only afford a $281,000 mortgage. So using our LVR of 80% this means we can only really afford a $350,000 property. Again, by thinking “well I’m ready to go with my $100,000, that’s my 20% deposit for a $500,000 property”, you not only need to look at the total CASH OUTLAY when buying a property but also your NET INCOME to see what mortgage you can really afford.

Up next… 3. What is my risk appetite regarding fixed versus variable mortgages?