Capitalising interest - risky or not?

[Gravos]

I just read something in last month's issue of API about capitalising interest - which I understand means paying the shortfall on an investment loan account from a line of credit. It was a strategy recommended by Michael Yardney whereas two other experts (someone from Property Planning Australia and also Margaret Lomas) said it was very risky and strongly recommended against it - presumably this is because the increasing debt as interest is ''capitalised'' will not necessarily be outweighed by capital gains.

I've done this with the one IP i have purchased to date (now getting to end of LOC) and I wanted to see what others experience with this practice of ''capitalising interest'' was?

cheers

 

[Rixter]

Everything in life is risky.

It's how you manage those risks that makes all the difference.

Capitalisation is not risky if you use this strategy within a portfolio that is invested for high CG and has the appropriate buffer level in place from the start.

Hope this helps

 

[jingo]

I've done this with the one IP i have purchased to date (now getting to end of LOC) and I wanted to see what others experience with this practice of ''capitalising interest'' was?

cheers

Hi Gravos,

Has your IP increased in value, and will you be able to increase the credit of your lOC?

Regards Jason.

 

[boomtown]

I just read something in last month's issue of API about capitalising interest - which I understand means paying the shortfall on an investment loan account from a line of credit. It was a strategy recommended by Michael Yardney whereas two other experts (someone from Property Planning Australia and also Margaret Lomas) said it was very risky and strongly recommended against it - presumably this is because the increasing debt as interest is ''capitalised'' will not necessarily be outweighed by capital gains.

I've done this with the one IP i have purchased to date (now getting to end of LOC) and I wanted to see what others experience with this practice of ''capitalising interest'' was?

cheers

Its also a function of how much interest you are capitalising versus the value of the underlying property against which the LOC is drawn. Its one thing to capitalise $100 per month to tip a slightly CF- IP cashflow neutral when the underlying property is worth $450k (ie you are effectively capitalising interest at rate of 0.2% pa which wouldnt bother me with a quality property - thats a rounding error) but it would be extremely risky to capitalise $1k per month against a property which is only worth $80k (effective rate of capitalisation of 15% pa).

But its hard to explain that in a quote in a magazine so its easier just to say dont do it.

 

[ffc1883_1996]

I think some people say capitalising interest is risky because it creates an illusion that of greater cashflow that one could blow on their lifestyle. To me, they’re totally separate issues.

Capitalising interest is not risky. Lifting your spending on debt funded lifestyle costs is.

This topic is very well covered in “How to achieve Wealth for Life” by Tony Melvin & Ed Chan. The book advocates using a capitalising interest structure to the REDUCE risk of running into cashflow problems with negative geared property.

 

[ianvestor]

The book advocates using a capitalising interest structure to the REDUCE risk of running into cashflow problems with negative geared property.

That's where risk comes down to an individual's mindset:

Some say investing is risky, some say not investing is risky.

 

[alexlee]

Buying property, risky or not?

 

[APerry]

I don't think there is any definaite answer to this question as it depends on the circumstances. Capitalising interest for a short term where their is a defined exit strategy eg in a development situation is less risky than trying to meet repayments you can't afford during that period. Similarly if you have very low leverage then it is a way of accessing your equity without having to sell, this does not seem particuilarly risky as ypou can always sell and turn your equity into cash.

Conversely, if you are relying on continual increaseases in the value of property to allow you to keep revaluing and increasing loans, then you are taking a very big risk. I have a very strong dislike for those cashflow loans because they encourage people to capitalise at high leverages and virtually force them to revalue and refinance after 3 or 4 years. In this situation, if there is a correction in the property market during this time and/or a tightening of credit markets (like at the moment) there will be people locked into very expensive loans that they can't service at high LVR's (potentially with loans that are higher than the value of their property.

Regards
Alistair

 

[Gravos]

Thanks for the very helpful replies.

The value of the IP has gone up - about 17% in the last year and something less than that in the previous year. Which means there is some equity (but still not much as it was a 100% loan and has only been 2 years holding). In any case I'll be moving the security for this loan over to the PPOR - where there is plenty of equity and using the IP as security for a further loan.

From the above comments I guess the thing to watch is the overall safety margins built into your portfolio i.e. overall LVR. Is the 'buffer zone' most people observe in this respect 80%? That was what I understood. We are still at about 50% taking the PPOR into account so I guess not being too risky in looking at another IP.

I do remember another quote of Michael Yardney's - credit is not risky per se, but not having access to credit is - or words to that effect.

 

[Rixter]

From the above comments I guess the thing to watch is the overall safety margins built into your portfolio i.e. overall LVR. Is the 'buffer zone' most people observe in this respect 80%? That was what I understood.

My LVR credit limit goes to 80%. The balance currently is 50 odd % on a portfolio capitalised rate of 0.66% p/a.

Hope this helps.

 

[Gravos]

Thanks Rixter

When you say your LVR credit limit goes to 80% but it is currently 50% does that mean you have access (eg with LOC) to draw up to 80%? And also how do you work out the capitalised rate - is it shortfall pa divided by property value? (and does this take into account depreciation, negative gearing etc?)

 

[ffc1883_1996]

I have a very strong dislike for those cashflow loans because they encourage people to capitalise at high leverages and virtually force them to revalue and refinance after 3 or 4 years.

Once you have a little equity, it is quite possible to capitalise interest without taking out a so-called “Cashflow” loan and without paying much extra in fees and interest.

 

[younginvestors]

Once you have a little equity, it is quite possible to capitalise interest without taking out a so-called “Cashflow” loan and without paying much extra in fees and interest.

Do you have any handy examples ffc1883_1996?

 

[Rixter]

Thanks Rixter

When you say your LVR credit limit goes to 80% but it is currently 50% does that mean you have access (eg with LOC) to draw up to 80%?

Yes exactly.

And also how do you work out the capitalised rate - is it shortfall pa divided by property value? (and does this take into account depreciation, negative gearing etc?)

Yes, cash flow shortfall p/a divided by estimated portfolio value x 100.

By 'cash flow shortfall' I mean the shortfall left after ALL portfolio holding costs have been deducted from my income after tax.

Does this help you?

 

[ffc1883_1996]

Do you have any handy examples ffc1883_1996?

I have a line-of-credit secured by my PPOR. All investment expenses, including interest, are drawn from this account. We never deposit any income into this account.

 

[Rixter]

I have a line-of-credit secured by my PPOR. All investment expenses, including interest, are drawn from this account. We never deposit any income into this account.

We do a similar thing.

We have an Investment LOC secured by some of our portfolio.

All rental income & tax savings are deposited into this LOC, and all portfolio interest & expenses are deducted from the same LOC.

The cash flow shortfall (difference between incoming & outgoings) is simply capitalised by default onto the LOC balance.

I have set all this up to operate automatically on auto pilot. My PM's pay all my expenses (except IP loan interest) for me from monthly rental funds collected, then they electronic transfer the balance left direct into my Investment LOC. All the IP loan interests are then automatically direct debited each month from the same LOC.

I hope this helps.

 

[Gravos]

All rental income & tax savings are deposited into this LOC, and all portfolio interest & expenses are deducted from the same LOC

Rick - so does that mean you pay tax saved from negative gearing into your LOC?

I use the LOC in the same way (PM deducts various expenses, balance rent gets paid in, I pay strata fees/rates etc from that LOC too) but I hadn't thought of calculating exact tax saved and paying that in - probably because we use it!

also does a program like PIA do these sort of calculations - for one property or across the portfolio?

thanks

 

[Psyk]

We do a similar thing.

We have an Investment LOC secured by some of our portfolio.

All rental income & tax savings are deposited into this LOC, and all portfolio interest & expenses are deducted from the same LOC.

The cash flow shortfall (difference between incoming & outgoings) is simply capitalised by default onto the LOC balance.

I have set all this up to operate automatically on auto pilot. My PM's pay all my expenses (except IP loan interest) for me from monthly rental funds collected, then they electronic transfer the balance left direct into my Investment LOC. All the IP loan interests are then automatically direct debited each month from the same LOC.

I hope this helps.

Certainly helps Rick.

Just out of curiosity, do you also access the same LOC fund as the deposit for another property?

 

[Rixter]

Just out of curiosity, do you also access the same LOC fund as the deposit for another property?

In the past yes, that LOC and a 2nd Investment LOC. However I am in the process of refinancing the 2nd LOC into the 1st at the moment for keeping the structure simple purposes.

Hope this helps.

 

[Rixter]

Rick - so does that mean you pay tax saved from negative gearing into your LOC?

Yes I place the tax portion saved from negative gearing into the investment LOC. I do this because its income directly generated from our investments. Without our investments this cash flow would never have been realised and would have been lost to the ATO for ever.

also does a program like PIA do these sort of calculations - for one property or across the portfolio?

PIA does generate an estimated tax savings but only based on the figures you input into it.

Each year we personally submit ITWV's and the ATO instructs our employer to deduct $xxx amount tax less each pay day. I have instructed our pay master to deposit this difference directly into our Investment LOC.

Do you follow what I mean?