Negative gearing and Interest only loans questions???

Hi Joe

Here is how it works:

You can claim, as a deduction, costs of holding the property such as insurance, property management, gardening, etc etc.  You can also claim the INTEREST the bank charged you on your loan. 

So.  If you take out a loan for say, $400k, the bank will require about $554 per week in interest from you.  Now.  Let's say your property earns $300 per week in rent.  So over a year, that is $300 x 52 = $15,600.  But sadly some of that income gets eroded in costs such as insurance, paying the property manager, the gardener, the council rates, the water and sewer service charges from the local water company, bla bla bla.  So let's say that after that, your $15,600 is eroded down to $11,000.  Where does that leave you?

Income less costs: $11,000
Bank interest: $554 x 52 = $28,808

Loss = $11,000 – $28,808 = LOSS of $17,808

This does not mean that you get a tax refund of $17,808.  It simply means that your taxable income is reduced by $17,808.  So let's say from your day job you earn $60k a year.  Normally, the tax department would calculate tax owing on $60k.  But in this case they would calculate tax owing on $60,000 – $17,808 = $42,192.

So this will result in some kind of tax refund. 

You must remember that it is only the INTEREST PORTION of the loan that is deductible, not the portion that is chipping away at the principal amount owing.

Now.  coming back to the business of you wanting to speed up paying off this house.  Why bother? 

Having a "Principal and Interest" loan (which appears to be what you are looking at doing) is essentially the same as having an "Interest Only loan with an offset account".  In both cases you are charged, and will have to pay, interest.  With the interest only loan, you can churn all your surplus money into the offset account (instead of onto the principal).  This will reduce the amount of money you are charged interest on.  Eventually, you will have $400k in the offset account, which is the same amount as the loan you took out, and thus the bank would no longer charge you any interest at all.  And if you're that way inclined, you could then give your $400k to the bank to pay out the principal, say "yay me, I own one house" and that'd be the end of that.

What's the difference you ask.  Well.  You can withdraw money from an offset account whenever you want.  For instance, when there is a big wad of cash in there, you could just withdraw it and use it as a deposit on a second property.  Conversely, if you had handed the cash over to the bank in a regular principal and interest loan, you'd have to ASK for it back, and pay FEES.  Now why would you want to do that.

Aside from that, interest only loans are better for investors as they help with cashflow.  The bank requires you to stump up less cash every month.  And if you hold onto the property for ages you enjoy the growth in value of the property, without having bothered to pay it off.  Nice.

So.  Get an interest only loan with offset.  Pay the interest portion only.  All extra cash into the offset.  And when that offset account is looking super healthy, pull that money out and buy another property!!  Remember, property goes up in value each year – faster than you can save money.  So the more properties you acquire, the more wealth you will create for yourself.  Then one day when you are older and have a whole bunch of houses all with debt on them, perhaps you'd opt to sell a couple of them to completely pay out the debt on the others, and live off the rents for the rest of your life.

Does this help you?

If you get an offset account instead of paying it off it's the same thing (in terms of risk) except you have access to the money when you want.

You may want to access this money for a deposit on a new IP (or something else). By paying off the mortgage the money now belongs to the bank.

And another thing to remember about negative gearing.  If you are negative gearing, it means you are making a LOSS.  A loss is a loss, doesn't matter which way you look at it.  It'd be much nicer to have a neutrally geared property, or positively if at all possible.  Loss – yuk. 

Hi Kate,

If you have a PPOR mortgage and a personal loan I would be putting any extra money that you have (assuming you go IO on your IP) and paying down that debt first as these are not tax deductible unlike your IP.
I could be wrong but I dont see the point in reducing debt that is tax deductible via an offset account if you still have non tax deductible debt.
Thats my opinion anyway.
Good luck with it all,

Nathan

As the others are saying, if you have a PPOR and also an IP, always put all spare money into the PPOR first and get that paid off, because its debt is non-deductible.

Back to the question about the 221D.  I haven't used a 221D yet but will no doubt have reason to in the future.  Think of it like this:

If you know with absolute certainty that your IP will leave you out of pocket AT LEAST $100 for each and every week for the entire year, I would definitely do the 221D.  Here is why:

Pretend the interest rate is 7.21% and that you are in the 37% tax bracket for income tax purposes.

The first week of the financial year, you "loose" $100.  At the end of the financial year, you would get some of this loss back.  Not all of it – some of it.  Your refund on this $100 would be, roughly, $100 * 0.37 = $37.00.  It doesn't sound like a lot, but when  you multiply that out by 52 weeks a year, that gives you a rough anticipated refund of $37 x 52 = $1924.  It'd actually work out a bit more because if you had those refunds in your pocket earlier, you would be able to whack that money straight into the offset account (or on your PPOR mortgage) and thus save some more interest, instead of waiting till the end of the financial year to get your tax refund.  Compounding interest is evil, and it is surprising how quickly small amounts grow to big amounts.

If you know with certainty you will make a loss, why wait till the end of the year to get your refund? 

Remember if you overestimate your loss, when it gets to the end of the financial year, you might owe the tax department some interest, so be slightly conservative in your estimates.

WOW JacM, you have an amazing way of explaining things.
Really appreciate the way you have communicated. It really helps.

My only regret is that I didn't find this website aaaaaaaaaages ago!
It is such a relief to find an environment in which all oddball questions are answered with integrity and shared knowledge – regardless of  how many times those 'same old questions' have been asked!!

Still working through the issue of IO vs P&I.

I understand the logic of paying off the principle for the purposes of a PPOR. However what if you don't have a PPOR, only investments? Wouldn't paying off the principle place you in an equally advantageous position in terms of future borrowings because you've reduced your debt? I don't see how reducing debt, thus improving LVR doesn't assist in expanding one's portfolio?

I would have thought the benefit obtained through keeping the interest payments at their highest (through IO loan) isn't as favourable in the long-term as paying off principle and putting yourself in the best position to expand.

Then again, having a healthy amount in your off-set will fund a significant contribution to future properties, thus reducing borrowings…provided you don't spend your off-set balance!

Sorry, I just don't see why paying IO on all investment loans is dramatically better than chipping away at debt…it seems in the long run, they work out the same…? IO loans only seem to provide short-term CF benefits and wouldn't having a healthy sum in an off-set reduce your interest payments there-by not maximising the interest deductible?

Now I'm really confused, I'm no accountant so please correct me!

It is not a bad thing to pay down the principal on an IP as long as you dont have any non deductible debt (Trust me i paid off
$9.6M in nearly 10 years on our portfolio) but it is the opportunityof cost that is the issue.

It is what you can do with the extra monthly amount that makes you different.

Sitting in a IP loan going nowhere or using it to fund deposits on the next half a dozen properties which over the next 10 years is potential going to make you a decent return is the difference.

Have said all that if you are comfotable and nicely living off the rental income of your portfolio why wouldnt you pay down the principal debt.

Cheers

Yours in Finance

Even if you don't have any private debt, there are at least two reasons why paying interest only on an investment loan is beneficial.

1. Your money is locked away and cannot be taken back without tax consequences, and
2. You end up paying more money per month so that means you cannot afford to invest this money elsewhere – the opportunity cost.

Imagine if you had 5 properties and were paying $1000 per month extra on each. that is about $60,000 pa. In 10 years this would amount to $600,000.

Now imagine that you had no spare cash and hadn't saved any extra, but you had $600,000 available in redraw. You want to upgrade your main residence. You would need to reborrow this $600,000 to purchase your new property. The trouble is that you would have to pay interest on this money and the interest would not be deductible as it has been borrowed for private purposes.

However, if you had used a IO loan with a 100% offset account and then saved the $600,000 in the offset you would have saved exactly the same amount of interest on your loans as if you had paid into the loan as an extra payment. But when you need your money for further private expenses you just take the money from the offset account rather than reborrowing it. This will result in the interest on your investment properties increasing again (because the balance on the offset account goes down), AND the extra interest on the investments will be deductible.

At an interest rate of 7% interest on $600,000 would equal $42,000 pa. Tax on this could be around $20,000. So that means you could have been around $20,000 pa better off by using an interest only loan in this example. Then add in the cumulative effects and the amounts are even larger.