When to stop focusing on negative gearing and start getting excited about cash flow!
Purchasing a home is part of the dream for a large percentage of Australians. You find a partner, get married, purchase a home and start a family. And for many, this home is enough. But there is always the discussion, or should I say pursuit, of reducing the debt on your own home as soon as possible. For many, this always seems like a long way off, but is always the goal. However, a growing trend in both the younger and older portions of the population is to shift to investing in property instead of, or as well as, buying their own home. It is here the thinking around debt changes dramaticaly.
This is because by purchasing an investment property, you are investing in securing an asset that works for you, to both minimise tax and build personal equity.
Tax minimisation in an investment property occurs through the claimable deductions you accrue, including property management fees, rates, water bills, and interest paid, otherwise known as negative gearing. So, when it comes to dealing with your investment property as opposed to your own home that you live in, the thinking around debt is completely different. Which is why we strongly recommend investors, take ‘interest only’ loans when it comes to investing in the property market to create this negative gearing effect.
By maintaining a high level of debt in the property, it ensures that the interest payable remains a high cost expense for you, and therefore the claimable tax deduction is maximised. So typically we recommend holding anywhere from 80%-100% debt against an investment asset and placing on an ‘Interest Only’ arrangement for the foreseeable future. However, common questions tend to arise when investors reach the end of the typical 5- year interest only period, and begin to wonder…
“When will I ever have this property paid off?”
So while we strongly recommend dragging out paying off your debt for as long as possible while the property continues to increase in value, there are in fact several circumstances where you may consider beginning to reduce debt on your investment.
SCENARIO 1: THE BANK FORCES YOU
At the conclusion of your interest only period, the bank with whom you have your investment loan may force you to change from an interest-only to a principle-and-interest, or P&I loan.
These forced changes may occur to make you less of a risk to the bank, as the debt you have with them is being reduced. So for whatever reason the bank gives, if that is the case, then it’s not the end of the world.
SCENARIO 2: INTEREST RATES APPEAR TO BE ON THE RISE
You may have 80 to 100 per cent of the loan amount currently sitting as the principle debt, but are sensing an impending interest rate rise.
If this is the case, you may feel it is a wise time to begin slowly chipping away at the principle debt; making your out-of-pocket expenses on that investment more manageable and not leaving you exposed should a massive spike come in the future. If the interest rates do rise and you are still only paying off the interest, you may find it difficult to generate enough cash flow to maintain payments on the interest of that principle amount.
SCENARIO 3: YOU WANT THE PROPERTY TO GENERATE BETTER CASH FLOW
There will inevitably come a time when you will need to choose between keeping your debt high in order to minimise your tax, or beginning to pay off the principal amount to generate a better return and better cash flow by minimising interest repayments.
Maybe you are looking to turn your investment into an income stream, to create better cash flow as you move toward retirement, rather than viewing it as a way to achieve better deductions. If so, it may be time to begin reducing debt as early as today!
SCENARIO 4: YOU NO LONGER HAVE A SIGNIFICANT TAX BURDEN
If you find yourself with a significantly reduced annual tax bill, because of either investing on a large scale, or changing employment scenarios, you may no longer have the need to reduce that tax burden drastically through negative gearing, as a tax burden may simply not exist anymore.
In this case, paying only the interest off will no longer be providing you with as much benefit, it will simply keep you in a significantly high level of debt. Reducing debt will help increase a more positive cash flow income as a result.
SCENARIO 5: THE MARKET HAS PEAKED
Lastly, you may be looking at the marketplace and seeing that it has been on a growth curve, peaked, and is now flattening out.
Perhaps now it is time for you to switch your focus, sell your property, and either take your profit, or reinvest in another area, should you feel in the future the risk of the market bottoming out is not on the horizon.
In our professional opinion, if these scenarios do not arise we recommend maintaining an interest only loan, in order to maximise your tax deductions for most situations. Of course everyone’s position is different and you should ask for specific advice for your situation.
If you have any questions, or require further information on investment borrowing or when it is best to reduce your debt, speak to the team at Catalyst Accountants, or visit one of our real estate industry partners BizScaping or Silverhall for more information about property investing.
As always we are here to help, so don’t be afraid to ask by calling us on 02 69774333 or dropping into the office at either
90 Loftus St, Temora NSW 2666
29 Brolga Pl, Coleambally NSW 2707