If you want to understand how does gearing work, then keep reading, because you can use it to jump start your nest egg.

‘Used wisely, gearing can turbo-charge your return on an investment.’

Borrowing to invest – also known as gearing

– is a way of using other people’s money to get ahead. Used wisely, it can turbo-charge returns on an investment. Gearing works very simply.

Gearing is generally a medium to long-term strategy of at least five to 10 years. But even modest amounts invested can generate real wealth given enough time and dedication to this method. Most of us are familiar with borrowing to make our biggest investment – our own home. So gearing works by simply applying similar principles when borrowing to invest in assets such as a share portfolio, or property.

Gearing can deliver a sound strategy to jump starting your nest-egg because it offers a way to increase the value of your total pool of investments by allowing you to put down a small deposit and borrow the rest. The key is to make sure the total return (income and growth) is greater than the cost of borrowing.

How gearing works

You provide either cash for a deposit, or other assets as security, and receive a loan to fund an investment. The main difference with this type of borrowing is that the loan is used for income-producing purposes. Buying a home that produces rental income, or buying shares that pay dividends are both examples.

When borrowing to invest, you need to consider different types of gearing. Negative gearing is where income from an investment (such as dividends or rental) is less than your interest and/or other expenses. Positive gearing is where income from an investment is higher than your interest and/or other expenses.

People hold a negatively geared asset for two main reasons. First, in Australia, you can typically offset any loss made on one investment, against other income, resulting in tax savings (which works well for those on high marginal tax rates). Second, the capital growth of the assets mean you can sell an asset for a capital gain that more than covers losses over the time the investment was held.

Is gearing right for you?

If you are still wondering how gearing works, depending on your circumstances, the benefits of gearing can include:

• If the investment is positively geared, you have access to a passive income stream (extra money in your budget) that can provide greater lifestyle choices.
• By borrowing to invest, the capital growth potential of your assets is greater. This is because of the greater capital base to begin with. You can use gearing within a self-managed super fund — as long as it complies with ATO rules.

It can be a great strategy if you have a long time frame because the more time your money has to earn, the more opportunity for compounding (adding any earnings received to the amount you contribute [principal] and then reinvesting them to create more potential earnings).

It is easy to see why gearing or borrowing to invest can provide a great approach to building wealth. Every year put off investing makes our ultimate retirement goals more difficult to achieve.

Investopedia provide a handy definition of gearing too.

If you’d like to chat about finance, please contact us.

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If you are wondering, ‘how can i pay off my mortgage faster?’ – for most of us, owning property is our biggest investment, but it doesn’t have to be the most expensive.

Regardless of what we owe, paying down the mortgage is a smart money move.

How can I pay off my mortgage faster – Easier said than done?

In fact there are numerous ways to reduce mortgage debt without putting undue strain on stretched finances.

Here’s 5 that won’t dent the budget.

1. Pay down the principal early

Did you know the point at which you pay the most interest is in the first years of your loan? That’s when the principal is at its highest, so the sooner you pay down the principal the better off you’ll be.

2. Make more payments

One of the simplest strategies to pay off your home loan faster and save on interest is to make extra repayments. By paying down your mortgage fortnightly, with many lenders you’ll pay 13 payments a year instead of 12. Of course, if you can make even more payments throughout the year, such as a lump-sum amount, you could save thousands of dollars and reduce your loan term. And given rates are at all-time lows, rounding up your repayment to pay that little extra also helps.

Before taking action on how can I pay off my mortgage faster

3. Check out package deals

Ask for a discount on your loan. Some lenders offer professional packages to specific professional groups or members of professional organisations that can shave up to 1 per cent or more off your mortgage rate. If you don’t ask, you’ll never know whether you’re eligible. And there’s often further savings tied to a package such as discounted home insurance, and fee-free credit card or transaction accounts. Also look into the benefits of all-in-one loans or 100 percent offset loans, which allow you to pay all your income into an offset account and then repay all your debt from the one account.

4. Consolidate all your debts

If you have more than one credit card or loan, pay off the one with the highest interest rate first, or tackle the smallest debt first. Better still, most lenders allow you to refinance all your debts under your home loan or an unsecured debt consolidation loan. If you have a mortgage and equity in your home, incorporating your personal debt onto your mortgage and increasing repayments could save a significant amount of interest. Consider what you’ll save by transferring credit card or personal loan debts with interest rates of around 15 to 20 percent to your home loan where interest rates are under 3 per cent! Just remember though, you need to increase your repayments so these debts don’t hang around for the life of your mortgage.

If you are really serious about ‘how can I pay off my mortgage faster’

5. Split your loan, or pay more off your fixed rate

It seems we don’t have to worry too much about an interest rate rise. However if you want to stick to a budget, fixing your loan is the way forward. But don’t fix the lot. You can hedge your bets by taking out a a split loan, which allows you to take part of your loan as fixed and part as variable. This way you can still make those extra repayments or lump sum amounts on the variable component of your “combination” loan. Already locked your loan down to a fixed rate? Check with your provider whether you can make extra repayments without penalty. Most lenders will allow you to pay an extra $10,000 a year off your fixed loan without incurring extra fees.

There are many more ways to reduce mortgage debt and save on tax at the same time.

ASIC publish a handy guide to paying off your mortgage faster too.

If you’d like to chat about finance, please contact us.

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Positive Gearing and Cashflow – ‘Know when to go with the flow.’

All positive cash flow properties are positively geared but not all positively geared properties are cash flow positive.

Yes, it might sound a bit complex but it is well worth taking a moment to understand it.

Choosing an investment strategy can be difficult. Choosing between positive gearing and cashflow can often be harder. As an investor a lack of cash flow can leave you in limbo. Making you unable to move forward to build up your portfolio.

I often hear from clients that they want a positive cashflow property, and for many investors who have spare savings. Combined with today’s low interest rates, this is quite simple to achieve. We simply put additional cash in as a deposit to reduce the costs of owning the property. Which brings them down to a level where the income exceeds the expenses.

A positively geared property is often what a client really wants. Many don’t want to use any of their spare cash even if they have some. What this means is that they actually want to make a profit. That is once they have got their rent in and paid their expenses out. Naturally at this point, it is likely that they are now going to have to pay some tax too. But at the end of the day, they don’t want to have to put any money from their own pocket in to subsidise the property in any way.

It is more about using these strategies for your own financial gain if you have the flexibility to do so.

So let’s look at a couple of examples of positive gearing and cashflow:

Based on a positively geared property — which generates more income than expenses before and after tax.

• You purchase an investment property and each month it brings in $1,000 in rent and you pay $700 in property expenses. At the end of the month, there’s $300 in cash spare ($3600 before-tax that year). After-tax, based on a marginal rate of, say, 47 per cent, not including Medicare levy or surcharge, you still have more than $150 per month in loose change.

Compare that to the scenario of a positive cash flow property — which generates a loss before-tax but more income than expenses after-tax.

• In this instance, your investment brings in $1,000 in rent each month but your property expenses are $1200. Before tax you’re down $2400 a year but once you claim, say, $10K in depreciation, based on an assumed rate of 30 per cent, your total loss for the year (on paper) is actually $12,400. Given you are entitled to claim back total expenses [at 30 per cent], you’d receive a refund of $3,720. In effect, you paid out $2,400 but got back $3,720 — a profit of $1,320 after-tax that year.

In this instance, your investment brings in $1,000 in rent each month but your property expenses are $1,200.

Of course, the level of equity or deposit put into an investment property purchase can affect the total annual cost of owning real estate.

Is there really a difference between positive gearing and cashflow?

Apart from the opportunity costs of any equity or cash you put down as a deposit. Taxation is where the opportunities differ. A positively geared property is one that delivers a positive cash flow after-tax but a positive cash flow property must generate a LOSS before-tax and a positive cash flow after-tax.

Put simply both strategies generate income, but the decision of what works really comes down to which one best benefits your circumstance: before-tax or after-tax.

That’s why it is important to consider your investment objectives. That is, you may have the cash sitting around in your bank account to buy a property outright. But if you borrow using equity in your home, you can increase the cost of ownership by the amount of interest the bank charges. Or you may prefer to borrow the full amount. Even if you don’t need to, it will increase the face value of the cost of ownership to maximise tax deductions and decrease overall costs.

To put that in perspective, it’s essential to understand that investment properties can be expected to earn either a good rental return or capital growth. Better still, both capital growth and a great rental return. If you are still trying to make sense between positive gearing and cashflow, then consider the following.

For more information, ASIC publish and handy guide to Investing and Tax.

If you’d like to chat about finance, please contact us.

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If you are wondering ‘do I need a deposit to buy a house?’, here is a quick and simple summary of how you can get into a property sooner.

‘We all want to achieve the great Australian dream.’

After all, owning our own home is life-changing. It offers security and more often than not leads to being financially better off.

Interest rates are at an all-time low.

Plus buying a house is exciting. What’s not fun is saving for the deposit.

So is a 10 per cent deposit enough to buy a house?

Yes, and no. The new deposit normal is now 20 per cent to avoid paying LMI (Lender’s Mortgage Insurance) — a one-off insurance payment that protects your mortgage lender against your default. This means you’re likely to only need a 5-10 per cent deposit.

Given most institutions are restricting the loan to value ratio they’re willing to extend to borrowers, LMI is usually payable if your LVR — the amount you need to borrow as a percentage of the purchase price — is above 80 per cent.

High property prices mean that most of us will need to put down a deposit to get a loan approved, and the more money we have, the less likely we’ll need to take out LMI.

Therefore putting a borrowing strategy in place is crucial in deciding whether to invest extra time saving up a large deposit, or paying LMI and applying for a loan with a small deposit.

Larger deposit versus a lower deposit

A downside is a small deposit attracts a larger LMI premium. On the plus side, some loans offer additional features, including lower interest rates to reward borrowers with bigger deposits.

Do I need a deposit to buy a house – work out what you can afford

There are many ways to save for a home that don’t require major changes to your lifestyle. So it pays to know how big a deposit you can afford. Work out how much you can regularly put aside and how long it will take to reach your goal — then stick to it. The easiest way to see results is to cut back on extras. And that’s where doing a budget helps.

Another tip is to open a high-interest savings account. Once you know how much you can save, make your money work for you. Don’t leave it in your everyday transaction account. Or if you plan to buy your home in a few years’ time, consider investing your savings in shares or a managed fund. Remember to always seek professional advice before making any investments.

Rent and invest when you trying to save a deposit to buy a house

Another way to get your foot in the property door is to rent and invest.

Of course, you’ll need to be realistic. On a $400,000 property purchase you could access a 95 per cent loan of $380,000, with a cash deposit of $20,000. So you may need to consider a smaller home, or a property in a different area. Just remember you’ll also need some money to cover the costs too (i.e. the governments taxes, etc.).

Whether you plan to buy, or invest in a home, it is a huge step — and it’s easy to be daunted by the large sums of money involved. With careful budgeting, saving money towards your property dream is made much easier.

ASIC publish a great guide to buying a house.

If you’d like to chat about finance, please contact us.

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If you are wondering if borrowing to invest is a good idea, we’ll look at the apartment lending crackdown: Fact v Fiction

‘Off-the-plan apartment buyers may not be able to finance their purchases when it comes time for settlement.’

This lending crackdown could quite possibly increase this risk for off-the-plan apartment investors who may not be able to complete their purchases because they can no longer get finance from the banks.

What’s the deal?

With the recent uncertainty in the market, the banks have reacted by putting stricter lending policies to investors in place. They did this by increasing interest rates, requiring borrowers to come up with bigger deposits, and even refusing to lend money at all. In other words, they’ve made it more difficult and more expensive to get an investment loan.

What does this mean for off-the-plan apartment buyers who are borrowing to invest?

These policies could be especially bad news for off-the-plan apartment buyers. In the past, buying apartments off-the-plan has paid off for many property investors. Even though buying off-the-plan apartments has always had some level of risk. But now, this lending crackdown could quite possibly increase this risk for off-the-plan investors. Many may not be able to complete their purchases because they can no longer get financing from the banks.

Here’s how it works with off-the-plan investing: Investors agree to buy the property – at an agreed-upon price – often before construction on the building even begins. Of course, part of the risk is that you never really know what the property market is going to do while the property is being built. (You hope the value of the property goes up.) Off-the-plan investors usually put down a deposit of 10 or 20%. And it wasn’t that long ago that banks were more than willing to lend money to property investors, financing that remaining 80 or 90%.

Preapprovals that expire before settlement

However, because property buyers can’t get approved for mortgage loans until shortly before settlement of an off-the-plan property. This is because pre-approvals are generally valid for only 90 days and still have some conditions. When you are borrowing to invest, you run the risk of not being able to come up with the outstanding money when the building is complete. Particularly if the bank’s lending criteria have changed since they contracted to buy. Thanks to the new guidelines, you risk defaulting on your contract, losing your deposit, and even facing a lawsuit from the off-the-plan developers.

This could impact a lot of property investors. For these investors, it may now be a lot harder to get that outstanding 90%.

ASIC publishes a handy guide on borrowing to invest too.

If you’d like to chat about finance, please contact us.

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People often ask us ‘is gearing good or bad?’

Here it is…

Understand (and use) the power of gearing.

What is gearing?

Gearing is essentially using or leveraging other people’s money to get ahead.

Used carefully and wisely, borrowing money can ‘turbocharge’ returns on an investment. Used incorrectly and in the wrong market conditions, it can be disastrous. Particularly, if you haven’t taken steps to reduce the risks.

With other people’s money, you can increase the value of the total pool of investments that your returns are generated on by putting down a smaller deposit and borrowing the money from someone else—normally a bank.

The key point

The key is to make sure the total return (income and growth) is greater than the cost of borrowing. This chart illustrates the power of using other people’s money.

If you are still wondering if gearing is good or bad

Above all, with any investment there is risk. When you rely on other people’s money to increase your return on investment, there’s a risk. However, when you manage the risk responsibly and carefully, you can benefit from using the power of gearing.

Ways to reduce risk

Income

A higher quality income source, or multiple sources of income, are often considered to be ways that you can reduce the risk of continuity of your income on any investment. Therefore, having 2 cheaper properties rather than 1 expensive one, means that if one of your tenants is unable to pay the rent, then hopefully you will still receive rent from the other property.

Expenses

Likewise, there a number of methods to reduce the risk of gearing, but one of the simplest ways is by fixing your interest rate. By capping the maximum amount of interest you’ll pay, you are reducing the risk that your costs will exceed your income.

Investopedia publish a guide to gearing ratios too.

If you’d like to chat about finance, please contact us.

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One of the most often misunderstood concepts is how negative gearing works.

‘A well-chosen property can deliver future wealth – not only from capital growth but also from rental returns.’

Most investors use some form of gearing against a mortgage to fund their rental property dream.

And that’s where the property buzz word, ‘negative gearing’, often comes in.

Put simply, negative gearing in the case of a property means borrowing to invest. The property is negatively geared when income from the investment is less than expenses. That is, the rental income received is less than the loan interest and other expenses being paid out. That’s how negative gearing works.

The benefit of this strategy is that you can adjust expenses to influence gearing by either borrowing more or less, therefore paying more or less interest. Because loan interest is a major expense, negative gearing can assist with the ongoing cost of maintaining the investment — because a loss can also be used to reduce taxable income.

How negative gearing works – an example

For example, you buy a property which brings in $25,000 in rent each year. The cost of holding it, including mortgage interest, is $35,000. You use the taxable loss ($10,000) to reduce your personal income and therefore also reduce the amount of tax payable on your salary.

Another benefit of negative gearing is being able to claim this loss throughout the year, which means you can increase your cash-flow. To do this, you need to apply to the Tax Office to reduce the amount of tax taken out of your weekly, or fortnightly pay. An Income Tax Withholding Variation allows you to make substantial tax savings and refunds sooner, rather than later when you lodge your annual tax return. And it is this strategy that can provide the biggest financial boost to build up a property portfolio.

By lodging a weekly, or fortnightly, tax variation with the ATO, you increase your take home salary, releasing potential funds to cover investment costs, such as owners corporation fees or rates. A perfect example of how negative gearing works in practice and provides a cash-flow benefit.

Moreover, it is important to know what expenses can be claimed as a tax deduction when a property is leased. For example, you can claim borrowing costs; landlord and building insurance; agent’s fees and commissions; repairs and maintenance costs; interest on the investment loan plus other bank fees; gardening; pest control and even cleaning costs.

You can increase your tax benefits by selecting a property to obtain maximum non-cash deductions, like depreciation. Depreciation spreads the cost of an asset over multiple years. It’s set up using a Tax Depreciation Schedule — a report outlining the depreciation of assets in the investment property, such as appliances and fixtures, that can also be claimed.

Negative gearing only benefits you in the long run if the money from the capital growth is greater than the overall loss in the rental shortfall.

It may seem counter-intuitive to be making a loss. But the end game is to make that up with a capital gain as the value of the property increases.

Given gearing can play a significant role your investment strategy, getting expert financial advice is key. Particularly if you need help identifying the right approach to maximise profits.

For a much more technical explanation, the Treasury publish a white paper on negative gearing too.

If you’d like to chat about finance, please contact us.

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Interest rates get a lot of attention and for good reason, so how do you get the best interest rate? They determine the cost of your loan and what you pay back. Even a small difference in rates can make a big difference to repayments, particularly on larger loan sizes.

But sometimes what appears to be the “cheapest” rate isn’t always right for you.

Australian banks and mortgage insurers have specific criteria they use to assess loan applications. If your situation falls outside their guidelines it can be expensive getting your application approved – in some cases interest rates can become less important. For example, if you want to borrow 80 per cent or more of the purchase price or property value (whichever is the lesser), mortgage insurance is likely to apply. The cost can vary dramatically between lenders. By shopping around a borrower can save as much as $2,000 (or more) on a loan size of $600,000.

Next there’s many types of interest rates: variable, fixed, split, introductory, P&I or investment-only
— each with their own advantages and disadvantages.

So you can see it takes a lot of work to sift through different loans and lenders to secure the best deal.

The devil is always in the detail. You need to know what you’re looking for to avoid getting caught in ‘discounted’ loan traps.

Don’t be dazzled by honeymoon interest rates

As the name suggests, they run for 12 months to two years but the life of your loan can last up to 30. To put that in perspective, a lender is generally unlikely to give you a discount for nothing, they’ll always try to get something in return, and it’s usually written in the fine print. After all, once they get you in the door, they don’t want to let you go.

Introductory offers take one of two forms: ‘fixed discount’ and ‘discounted fixed’ interest rates. The fixed discount is a rate that is variable, but fixed at a certain level or margin below the standard variable rate. During the introductory period, this means the discounted rate will move with the market. The discounted fixed rate is a rate fixed for the introductory period of the loan, and won’t move with the market.

Some lenders may also ‘cap’ or limit the amount of extra money you can pay off the loan during the introductory period, which, in turn, may limit the benefit of having the introductory period.

So what should you do to get a clear picture of the best value loan? Compare interest rates, product features, and fees and charges because they can add up to thousands of dollars over the life of your home loan.

Comparison rates

Always compare interest rates, product features, and fees and charges.

In the example, home loan B will cost less than home loan A, even though home loan A has a lower interest rate. However, ensure the features being offered by each loan suit you.

If that sounds like too much of a hassle, a mortgage broker will help you navigate the home loan mine-field. They will help you to find the best home loan combination for you. Best of all they’ll start with policy and analyse which lenders might provide the amount you’re seeking to borrow and match the best interest rate, along with product features and other associated fees and charges. Above all they’ll create a tailored plan that best suits the life of your loan.

If you are interesting in looking at the history of Interest rates in Australia, the Reserve Bank of Australia publishes some useful data.

If you’d like to chat about finance, please contact us.

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