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How to negatively gear with out negative cashflow

by Greg Carroll at www.attitudefinance.com

 

As we have discussed in previous articles the way to create wealth through investment assets is by holding them over the long term. If you purchase an investment property and it grew on average by 7% pa, then it would double in value roughly every 10 years.

 

On that basis you could buy a property today for $250,000 and it would be worth $500,000 in 10 years time. This capital gain provides additional equity for further investment and future wealth. Obviously higher growth property will allow you to build a portfolio more quickly. However this type of property will tend to be cashflow negative in the early stages. Therefore you will need to fund the shortfall until it becomes positive. This early period can place some pressure on cashflow and can often lead to investors selling their investment before any significant gains are fully realised. Which is a shame.

 

The impact of this negative cashflow can be minimised with the correct loan structure. The following example illustrates.

 

EXAMPLE

Phil Smith is planning to buy an investment property for $300,000. His existing home is worth $500,000 with a loan of $200,000. The total costs for the investment purchase are $315,839.

 

Firstly to avoid cross-securitisation we set up Phil's loan structure as illustrated in table 1.

 

TABLE 1

 

Security

Value

Loan type

Loan amount

LVR

Home

$500,000

Home Loan

$200,000

 

 

 

Investment Loan to cover 20% deposit plus costs

$75,839

 

Sub-total

$500,000

 

$275,839

79.9%

 

 

 

 

 

Investment property

$300,000

Investment Loan

$240,000

 

Sub-total

$300,000

 

$240,000

80%

TOTAL

$800,000

 

$515,839

 

 

 

We also set up an additional $124,000 Line of Credit Limit as illustrated in Table 2.    

 

TABLE 2

 

Security

Value

Loan type

Loan amount

LVR

Home

$500,000

Home Loan

$200,000

 

 

 

Investment Loan to cover 20% deposit plus costs

$75,839

 

 

 

Line of Credit

$124,000

 

Sub-total

$500,000

 

$399,849

79.9%

 

 

 

 

 

Investment property

$300,000

Investment Loan

$240,000

 

Sub-total

$300,000

 

$240,000

80%

TOTAL

$800,000

 

$639,849

 

 

 

Let's assume the following:

 

  • Rent on the property is $300 a week
  • CPI 3.00% pa
  • The interest rate on all loans is 8%
  • Capital grow will average 7% pa over the next 10 years
  • All rental income will be paid into the Line of Credit
  • All interest and expenses will be paid from the Line of Credit
  • Phil only makes the minimum monthly payment on his home loan

 

Table 3 illustrates the results over the next 10 years

 

TABLE 3

 

 

Start

Year 1

Year 2

Year 3

Year 5

Year 10

Home Loan

$200,000

$196,676

$194,729

$192,621

$190,338

$175,745

20% Investment Loan

$75,839

$75,839

$75,839

$75,839

$75,839

$75,839

Line of Credit

$0

$7,968

$16,080

$24,989

$44,971

$109,251

Home Value

$500,000

$535,000

$572,450

$612,521

$701,275

$983,575

 

 

 

 

 

 

 

Investment Loan

$240,000

$240,000

$240,000

$250,000

$240,000

$240,000

Investment property value

$300,000

$321,000

$343,470

$367,512

$420,765

$590,145

 

 

 

 

 

 

 

Total lending

$515,839

$520,483

$526,648

$533,449

$551,148

$600,835

Total value of property

$800,000

$856,000

$915,920

$980,033

$1,122,048

$1,573,720

Net worth

$284,161

$335,517

$389,272

$446,584

$570,892

$972,885

 

 

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

 

  • Phil has not had to contribute any additional funds from his own pocket other than repayments to his home loan which he had to make in any case. Therefore his day to day cashflow has not been impacted while his wealth grows
  • Over 10 years Phil's net worth has increased to $972,885
  • If Phil had done nothing and just continued to pay off his home his net worth would have been $807,821 - $165,064 less than following his investment plan
  • While overall Phil's debt did increase the value of his assets increased at a higher rate
  • Even after 10 years Phil has still not used all of the original line of credit of $124,000

 

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 Phil making additional payments into his home loan as this would reduce his non-deductible debt and increase his net worth.

 

In the next months issue I will show how you can take this strategy one step further and pay off your home loan in under 10 years.

 

 

This article is not a substitute for independent professional advice. We do not warrant the accuracy, completeness or adequacy of this information. All information is subject to change without notice. We and each party providing material displayed in this article disclaim liability to all persons or organisations in relation to any action(s) taken on the basis of currency or accuracy of the information or material, or any loss or damage suffered in connection with that information or material. You should make your own enquiries before entering into any transaction on the basis of the information provided. Please ensure you contact us to discuss your particular circumstances and how the information provided applies to your situation.