Investing Case Study - Dave is looking to buy his first investment property
Living in the home he bought ten years ago, Dave has now paid off his first home loan and is now in a financial position to start growing his property portfolio. At 40, the engineer is keen to build on his wealth as he has early retirement in his sights!
Dave has decided to buy an investment property to make money as it’s less volatile and risky than purchasing shares. Dave is keen to invest in a two bedroom unit in the sought after eastern suburbs of Sydney. Having done his homework, Dave has learnt that rental income is high in the area as there are plenty of schools, hospitals and shops in close vicinity.
Dave books an appointment with the bank, (the same one he has his first home loan with) to discuss options for an investment loan of $600,000. Having done a substantial amount of research on recent sale prices in the eastern suburbs Dave is realistically looking to invest in a $750,000 property. While living on a tight budget, Dave has been able to build up cash in a savings account, hitting his target of $150,000. This is 20% of the value of the new property he is looking into. Anything less and just like his first home loan, Dave would have to pay lenders mortgage insurance (LMI). This insures the bank against you not being able to make your mortgage repayments.
Considering interest only repayments
One of the first aspects the bank manager discusses with Dave is the type of investment property loan he can sign up with. Unlike a standard home loan where you pay interest and principal, there is another option of paying just the interest for an introductory period. Interest only repayments mean Dave’s monthly repayments will be a lot lower than if he was paying principal as well. Unfortunately for Dave and other property investors, the interest only period doesn’t last forever, usually five years is the limit!
Using a home loan repayments calculator, Dave can see how an interest only loan will work in his favor. Borrowing $600,000 for a 25 year loan term (with an interest rate of 5.25%) and paying interest only, Dave’s monthly repayments will be $2,625. However if Dave was to pay principal and interest then his monthly repayments would be $3,595 which is significantly higher.
Knowing his tax concessions as a property investor
The bank manager also advises Dave that the added benefit of choosing an interest only home loan for an investment property is negative gearing. To explain it simply, negative gearing is when the income from an investment property is less than the expenses of owning the rental property each year. This creates a taxable loss which can then be claimed back come tax time!
With the figures above, Dave will pay $31,500 in interest each year as well as $5,000 in property expenses (maintenance, council rates, water rates and body corporate fees), for a total of $36,500. Looking at average rental prices in the area for a two bedroom unit, Dave is predicting he’ll receive $26,000 income in rent per year. Therefore Dave has a taxable loss of $10,500 which he can use to reduce the tax payable on his salary.
Picking the type of interest rate to go for
Having chosen an interest only investment loan Dave now has to choose the type of interest rate that will best suit him. There are three main options; variable interest rate loan which changes with the rise and fall of market rates, fixed interest rate loan where the rate is locked in for the fixed rate term or a split interest rate which is a combination of fixed and variable rates. Dave’s first home loan has a fixed interest rate which he is happy with as it makes budgeting a whole lot easier with set monthly repayments. However Dave is looking for more flexibility with the investment property loan and additional features such as an offset account. So without hesitating he chooses a variable interest rate loan.
Considering the investment loan features
An additional home loan feature Dave has been advised to go with is one that has an offset account. Any money in the offset account will reduce the amount of interest Dave pays on the loan and once he builds up the money in the offset account he can access it and use it as a deposit for his next investment property! Once Dave signs the dotted line on the investment property loan he will then have his salary deposited into the offset account linked to the mortgage.
Getting his home loan paperwork sorted
With all the big decisions made in regards to the investment property home loan, Dave now needs to provide the bank with some crucial documents for his application to be processed. He has to prove his identification with a certified copy of documents like his passport, birth certificate and Australian driver’s licence. The bank needs to determine if Dave will be comfortable in servicing an investment home loan so he’ll have to provide his latest PAYG Payment Summary from his employer as well as a contract outlining his salary. As Dave has an existing home loan he needs to provide 3 months’ worth of statements to show he has been making his monthly repayments. To prove he’s a disciplined saver Dave will also provide copies of his savings account statements.
With all the documentation sorted Dave will now patiently wait for his application to be approved but in the meantime he’s going to start looking for the ideal investment property, starting in Australia’s iconic suburb of Bondi!