by Greg Carroll Attitude Finance www.attitudefinance.com

 

Last month I discussed how your loan structure not just the interest rate can affect your ability to meet your commitments and maintain your lifestyle. This month I would like to explore that idea further as it relates to investment.

 

As an investor I believe you need to look at your investments like a business. Anyone who has been in business for even a short period of time understands that a business takes time to build. While you can crunch the numbers over an over, map out plans and strategies of how things will unfold, ultimately you really don't know until you jump in. And often the reality both in terms of costs and time frames can be markedly different from your original plans. And while the focus of every business will be to grow, make a profit and improve returns, any business owner will tell you that the life or death their business is all down to cash flow.

 

And so it is with investment. Cash flow buys you time. It means if rates rise, unexpected costs occur or your circumstances change you have room to move, rather than being backed into a corner.

 

So let's look at a finance structure to acquire an investment that gives you time.

 

 

EXAMPLE

Bill and Lori Jones are planning to purchase an investment property for $350,000. Their home is currently worth $600,000 with a loan of $252,000. Estimated purchase costs are $14,615. Starting rental is $300/week. Average annual growth is 7%. Bills earns $85,000 pa and Lori $25,000. Their living expenses are $5,000 per month.

 

To purchase this property the suggested structure for Bill and Lori would be as follows:

 

TABLE 1

 

Security	Value	Loan type	Loan Limit	Loan Balance	LVR
Home	$600,000	Home Loan	$252,000	$252,000
		Line of Credit	$228,000	$84,615 (Financing 20% of purchase price plus costs)
Sub-total	$600,000		$480,000	$336,615	80.0%
Investment property	$350,000	Investment Loan	$280,000	$280,000 (Funding remaining 80% of purchase price)
Sub-total	$350,000		$280,000	$280,000	80%
TOTAL	$850,000		$760,000	$616,615

 

 

Under this structure:

 

·         They are still financing 100% of the purchase price plus costs maximising their tax deductions.

·         They are separating each property so they are not cross-securitised. This means in the future they can refinance or sell one of the properties without affecting the other and avoid potentially higher costs.

·         They have provided themselves a buffer of $143,385 to assist with funding the investment property.

 

So a possible scenario under this structure would be as follows:

• Bill and Lori direct surplus income after living expense into their home loan
• Rental income is directed towards line of credit
• Investment Loan payments are paid from line of credit
• Investment property expenses are paid from Line of Credit
• We will assume an interest rate of 8.5%

 

 

Table 2 illustrates the projected results over the next 5 years

 

TABLE 2

 

	Start	Year 1	Year 2	Year 3	Year 5
Home Loan	$252,000	$249,681	$245,072	$237,907	$214,721
Line of Credit	$84,615	$94,500	$120,715	$148,765	$210,893
Home Value	$600,000	$642,000	$686,940	$735,026	$841,531
Investment Loan	$280,000	$280,000	$280,000	$280,000	$280,000
Investment property value	$350,000	$374,500	$400,715	$428,765	$490,893
Total lending	$616,615	$624,181	$645,787	$666,672	$705,614
Total value of property	$950,000	$1,016,500	$1,087,655	$1,163,791	$1,332,424
Net worth	$333,385	$392,319	$441,868	$497,119	$626,810

 

 

There are a couple of things to note from this example.

 

• Bill and Lori have not used their day to day cash flow to fund the investment property.
• Their debt has increased by 13% but their net worth has increased by 88% and they now hold two properties as opposed to 1.
• To acquire that same property in 5 years time would cost them $490,893 plus costs.  
• We have assumed average growth of 7% per annum. Growth for Brisbane last year was around  20%
• If Bill and Lori's living expenses were $4,000 per month their total debt after 5 years would be $631,172 - meaning their net worth would be $701,252.
• Bill and Lori's starting loan limit against their home was $480,000. The debt against their home at year 5 is $425,615.

 

The above example challenges our generally held belief that more debt is bad and that to get ahead debt should go down. Of course there would be nothing wrong with Bill and Lori making additional payments into their home loan as this would reduce the non-deductible debt and increase net worth.

 

Next time I will take the strategy one step further and show you how Bill and Lori could pay out their home loan in under 6 years.

 

 

 

 

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