Extra repayments and the impact on tax of yield?

[dynamite]

Im struggling to get my head around this fundamental.

Lets say I neutrally gear a property, the yield is just paying the interest.

If I start to pay extra repayments from my own salary, this reduces the interest payable.

The more interest I reduce the less the yield is paying interest and starts to pay principle and starts to become eligible for income tax because of this?

So effectively the more I pay off an IP the more tax I am paying, which reduces the benefit of extra repayments and I am increasing my taxable income?

So would it be more cost effective to keep a property neutrally geared, and save the extra repayments and invest them elsewhere, then pay the IP off in one lump sum?

Is there a calculator that shows the impact to yield tax based on extra repayments?

 

[Aaron_C]

That is correct dynamite. While have a positively geared property is good (because more money in your pocket), the MARGINAL benefit of doing so is significantly reduced because 30-45% of it goes straight to the government.

 

[dynamite]

thanks !!!

 

[Aaron_C]

I think before you do anything you have to get out of the mindset that 'I have to pay these loans back'. You don't until 30 years time (assuming you let them run their course).

Best strategy I think is to maintain the status quo. Do not pay them off ASAP. If your long term goal is having 4 IPs - hopefully by the time you retire you can just sell 1 of them to pay out all of the IP debt and have 3, unencumbered properties that you can use later to access equity or do whatever you want with them.

 

[dynamite]

nice one thanks.

im thinking more like 10-15 years by the way hehe.

 

[Aaron_C]

Well the thing that limits property purchases is income - capital itself isn't the big issue. So if you can increase income you will be fine

 

[dynamite]

i see. is there a calculator online for multiple property borrowing power?

im thinking on $100k is it possible to borrow 75% of $1.2mill (4x300k properties)

mind you this is a couple of years off anyway, but i want to get some strategies/goals in place now.

 

[Aaron_C]

It's pretty easy to work out. Banks only take 75-80% of your property's rental income into consideration when calculating servicing. Simply divide that rental income by 0.09 (which is 9%, the current servicing rate) and you will have how much you can borrow off that income alone. Of course you also need to consider your LVR etc too

 

[dynamite]

so 80% of net yield, divided by .09?

ie 20000 x .8 = 16000, 16000/.09 = 177778, for a properly net yield of 400 dollars per week.

would my salary have any impact on borrowing power for rentals?

ps: thank you very much for your help.

 

[Aaron_C]

that's correct. it's a good rough approximation

 

[mech81]

It's pretty easy to work out. Banks only take 75-80% of your property's rental income into consideration when calculating servicing. Simply divide that rental income by 0.09 (which is 9%, the current servicing rate) and you will have how much you can borrow off that income alone. Of course you also need to consider your LVR etc too

Thats good to know. Thanks Aaron!!

 

[Peter_Tersteeg]

It's pretty easy to work out. Banks only take 75-80% of your property's rental income into consideration when calculating servicing. Simply divide that rental income by 0.09 (which is 9%, the current servicing rate) and you will have how much you can borrow off that income alone. Of course you also need to consider your LVR etc too

I think this grossly over simplifies things as you're missing the "cost of living" allowances assuming there is nothing else in the equation. Additional income from the borrower, other debts, different policies on different income. I really wouldn't want to rely on this calculation at all.

The easiest way to get an accurate summary of your borrowing power with different lenders is to spend 30 minutes with a broker.



I take a different view on neutrally geared properties, extra payments and tax...

This thread has focused on maximising tax deductions which is fine, but keep in mind if you're paying tax, it means you're actually making money!

If you start to pay down your loan, your property will eventually become positive cashflow and you will have to pay some tax on this as it's considered 'income'. The good news is that after you've paid the tax, you get to keep the rest and do what you want with it!

You could even invest it and potentially make more money!

There's essentially two ways to keep a property neutrally gear, assuming that rents go up with inflation and interest rates don't change...

1. Don't increase the rent. This will keep the property neutrally geared and you won't ever have to pay any extra tax. The problem is you're missing out on the extra rent which you could easily get.

2. Keep borrowing against the property so it never becomes positive cashflow. As the rent goes up, you borrow more. If you use the money borrowed to invest further, this can help your wealth creation path (but you might end up paying some more tax somewhere else). If you spend the borrowed money on lifestyle stuff, it won't be tax deductable and it will mean more debt to pay down if you do sell the property in the future.

If you've got non-deductable debt you should focus paying that down first. After that, if you don't have anything else to do with surplus cash, pay down other debt. Don't sweat it if your property is positive geared and you have to pay some tax on the surplus income. It means you're making money.

 

[dynamite]

Don't sweat it if your property is positive geared and you have to pay some tax on the surplus income. It means you're making money.

that was my initial thought too.

but then i thought if i do extra repayments, for every dollar positively geared (due to my extra repayments) i would be paying 37 percent tax. where as if i saved those extra repayments in bank account, i would A) gain interest on the repayments, B) pay off the principal of the loan when i have saved enough and avoid having paid 37 cents for every dollar the property makes positive. wouldnt this pay off the loan quickeR?

i hope that makes sense, i struggle to explain my thoughts as im not that great at problem solving in my head hehe. i could be way off with my thinking so if i am thanks for all the input.

 

[Deltaberry]

Completely agree with Aaron.

To go from negative gearing to positively gearing is silly. Look at the calcs (note I thought about doing this in algebriac fashion but figured this would be more easily digested by many here):

• At 7% interest rates, a $500k loan will cost me $35k. But because I'm on a 48% tax bracket (thanks to medicare levy and flood levy), it is really only costing me $18k. In other words, my true mortgage rate is 3.6%.
  
  
• If I had $500k, I am much better off throwing that money in to the share market. A franked dividend yield of 10% from Telstra will earn me more than the 3.6% interest I save.

As usual, I thank thee taxpayers for bankrolling my Telstra shares and houses.

 

[Peter_Tersteeg]

Deltaberry has correctly pointed out that there are alternate investments to property into which you can put your money. There's no arguing that it can be very effective to use franked dividends and other strategies to your advantage. All I'm suggesting is that you shouldn't be afraid of positive geared property.

If you're going to put your extra cash into a simple savings account, it's not going to be a great strategy. You'll earn interest on the savings, which you may have to pay some tax on.

A savings account might earn you 5%. After the tax free threashold you'll have to start paying tax on this.

A better place to put your cash would be an offset account. It'll save you around 7% and there's no tax in sight. The cash is still available for other investments.

A better approach as Detaberry has pointed out would be to invest the money into certain shares, earning a dividend and attracting franking credits. This can actually help pay for negative gearing costs and builds an additional investment portfolio which (hopefully) grows in value.

In isolation, it's a good thing to pay down debt which is where I say the original question heading. A more diversified strategy can be used to better direct the debt to other investments.

 

[dynamite]

i didnt mean literal bank account, i just meant it as an example. ;-)

edit: for get the scenarios, im confusing myself

 

[Perth Investor]

So if scenario B is better, why then would you take that money and pay off your debt, when you can leave it where it is and make more money??

This is the whole point of interest only loans, it leaves you more cash to put towards more investments.

Unless you are nearing the end of your investment strategy, normally you would have more debt at 30 than 20, more at 40, more at 50, only after this would you normally start to decrease.

So why bother paying it off if you are just going to borrow more again later? Bung it in an offset account and take it out for more investments as you need it.

This is excluding any information regarding non-deductible debt, and perhaps a strategy where you are debt reducing due to the investment cycle etc. But even then offset accounts are mostly the answer.

 

[dynamite]

removed the scenarios as i thinking im starting to confuse myself hehe.

 

[Terryw]

No one mentioned this above, but if you have any non-deductible debt then it would be far better to pay this off first.

Before when I was a broker I had met several people who had debt on their home loans but wanted to pay down investment properties first so as to make them positive cashflow. Their reasoning was that positive cashflow is good.

 

[Terryw]

that was my initial thought too.

but then i thought if i do extra repayments, for every dollar positively geared (due to my extra repayments) i would be paying 37 percent tax. where as if i saved those extra repayments in bank account, i would A) gain interest on the repayments, B) pay off the principal of the loan when i have saved enough and avoid having paid 37 cents for every dollar the property makes positive. wouldnt this pay off the loan quickeR?

i hope that makes sense, i struggle to explain my thoughts as im not that great at problem solving in my head hehe. i could be way off with my thinking so if i am thanks for all the input.

Dynamite,

This doesn't make sense.

Because you will be paying 37% tax on the savings account interest as well. You could be making (or really saving) 7% in the home loan or % (up to) with the savings account. Both would result in the same tax rates, but the savings account is a lower income.

It could work if you had a spouse on a lower income though. You gift her the cash and she earns interest on it paying less tax.