Tell me more about using debt to fund debt.....

[Shuttergirl]

I was reading the other thread with the poll about debt to fund debt and it seems to be something that many of the Somersoft 'pros' are doing.

Can someone please explain to me the "wheres/hows/whys" of this and the benefits? It sounds intriguing and I feel that in the future these are things that I will need to know so................

Can anyone give me a "using debt to fund debt for Dummies" crash course?

 

[MarkB]

Well the simplest way to use debt to fund debt is through refinancing.

I've only ever saved (out of my income) the money for one deposit (IP #1). Every IP since has been bought with the deposit proceeds effectively borrowed from another.

Sure, you're effectively borrowing 100% of each new purchase, but with an appreciating market your gross assets are rising faster than your gross liabilities, so your LVR falls and your net assets increase.

Servicibility (and CG) permitting, you keep going.

And when your servicibility runs out, you move to low-doc and no-doc loans at lower LVRs.

M

 

[toony]

An example.

Refinance - use LOC.

Rent $4k
Exps $5k. per month.

I take the $1k from my redraw/LOC and increase my amt owing to pay for the shortfall. The assumption being that my gross assets with exceed the $12k my loans increase over the 12 month period.

 

[The Y-man]

Another example:

I borrow $50,000. The interest (for ease of example) is 10% pa.

I want to prepay 1 year's interest, but I don't have enough cash. So I borrow another $5,000 to pay the interest on the $50,000.

I may then pay off the interest and/or pricipal of the $5,000 loan on a monthly basis.

Cheers,

The Y-man

 

[Melbear]

My example

I borrow $100,000. The interest is 8% or $8,000.

My choice is to invest in the share market where I am conservatively earning 24% pa or $24,000. I pay $8,000 for the loan, and then have $16,000 to put towards the interest payments on my other loans - or I put it back into shares to create my buffer for when the market corrects - or god forbid I spend a little bit of it

 

[Shuttergirl]

okay so what you are saying is that I could use my LOC to cover any shortfalls between my IP's rent and my mortgage payment???

Is that so that you don't tie up too much of your personal income?

I want to prepay 1 year's interest, but I don't have enough cash. So I borrow another $5,000 to pay the interest on the $50,000.

I may then pay off the interest and/or pricipal of the $5,000 loan on a monthly basis

.

Y-man, when you say pay a year's interest in advance, is that on your PPOR and can you explain to me the benefits of doing this?

 

[s_t]

My example

I borrow $100,000. The interest is 8% or $8,000.

My choice is to invest in the share market where I am conservatively earning 24% pa or $24,000. I pay $8,000 for the loan, and then have $16,000 to put towards the interest payments on my other loans - or I put it back into shares to create my buffer for when the market corrects - or god forbid I spend a little bit of it

Mate that is fine, but I hope you haven't based your plan on "conservatively earning 24% pa". Sure might happen some years, but if your expecting that every year, or even that as an average, then you're likely to be rather disappointed. That is the main risk with funding debt with debt (especially if taken to the limit) - expected returns on money that are unrealistic or rather volatile.

 

[The Y-man]

Y-man, when you say pay a year's interest in advance, is that on your PPOR and can you explain to me the benefits of doing this?

My understanding: for a benefit to exists, several factors must be there.

1. the money borrowed must be used for an income producing purpose
2. the lender must offer an advantage of prepayment of interest (eg lower interest rates)

Scenario.

In June of 2008 you prepay interest for the next 12 months (July 2008-June 2009)

You can claim the interest expense for the 08-09 FY in the 07-08 FY (this is a "by-product" and must not be the primary reason you do this arrangement)

Cheers,

The Y-man

 

[grossreal]

hi all
here is another way
a 500k commercial with what I call a ratchet lease so its is a annual increase of 5% or cpi which ever is the higher.
the loan is say 80% so that 400k
to work out what your coverage of income against loan you take the net income and divid by the interest rate at the time so say you have a 51k net income divide that by 8% that gives you a coverage of 637k.
now a commercial is valued at about 6.5% here in sydney at the moment
so if you take the 51k and divide it by 6.5% thats a value of 784k so you take 20% away and thats 627k that a lender will lend you no problems. so you have a cost of 400k with a potential borrowing of 627k so you have 227k take out your 100k you put in the first place you have 127k to use elsewere.
so you fix your loan for 5 years.
now lets look at 5 yeras down the track
you have a income net 65k with the ratchet of 5% annually( tennant has paid all out goings, if the cpi is higher the 5% ie interest rates have moved you have increase the rent to cover)
you now have a coverage of 813k and a val of 1mil so you take 80% of the 1mil 800k
take out the 627 leaves you with 173k to invest elsewere and at all time the debt is covered.
by having the lease for 10 years with a ratchet you will have the initial funds back and invested else where and you have a true val of your property.
if you put the above on excell its easier

 

[ffc1883_1996]

use debt to fund ALL investment expenses

Hi Shuttergirl,

I think the main lesson here is to use debt to fund ALL investment expenses (purchases, costs, interest, etc). Try to never use after-tax cash or income.

This is very hard to do for your first property but should be possible once you have some equity.

Regards - Ben

 

[Twitch]

Using debt to fund debt is a higher risk strategy than not doing so. It should therefore be used with caution and should not be a default strategy for all property investors.

It can be a good tool for asset rich-income poor people who want to acquire/keep assets that will show strong captial growth, and are preferably diversified into different markets.

The strategy will punish those, for example, who used the strategy to hold a single asset that is moderately to very negatively geared, but did't grow for the first few years after purchase.

cheers

 

[ffc1883_1996]

only punish those who "blow" their cash

Hi Twitch,

I think the strategy would only punish those who "blow" their cash and taxable income on the false premise that their asset is appreciating. If the income is being saved, or used to offset non-deductible debt, then using debt to fund debt is a LOWER risk strategy than not doing so because of the tax implications.

When capitalising debt, the real trick is not to be drawn into increasing personal spending.

Regards - Ben

 

[landlubber]

Using debt to fund debt is better (a) when your IP portfolio is GROWTH oriented and (b) the lower your LVR the better/safer it is. A simple example is as follows.
a) IP portfolio of $5m growing at average of 8%pa = $400K increase in equity each year compounding
b) loans of (say) $3m at 8% pa interest = $240K per year compounding.
c) neg gearing on portfolio (say) 50K per year ( goes down when rents increase, goes up when interest rates go up.)
d) personal living expenses (say) $50K per year.

With the above numbers you have replaced your income ( retired ??) have all your costs covered (from growth in equity (that meas more debt each year) ) and you still increase your nett worth by $60K per year.
($400K less $240K less $50K less $50K = $60K)

So ..simply..property increases each year AND debt/loans also increase each year. If you aren't comfortable with this situation , then maybe it's not for you.

You can adjust the numbers to suit yourself. ( e.g. currently 8% is conservative growth for most resi. IPs but it pays to be conservative ...)

Good luck
LL

 

[jingo]

Using debt to fund debt is a higher risk strategy than not doing so. It should therefore be used with caution and should not be a default strategy for all property investors.

It can be a good tool for asset rich-income poor people who want to acquire/keep assets that will show strong captial growth, and are preferably diversified into different markets.

The strategy will punish those, for example, who used the strategy to hold a single asset that is moderately to very negatively geared, but did't grow for the first few years after purchase.

cheers

Hi Twitch,

I agree with you. In my opinion this strategy is agressive, and needs to be used with caution! (ie, with the ability to come up with cash to fund any shortfall due to unexpected situations).

The strategy relies heavily on achieving capital growth of a certain % each and every year.

If you employ the strategy, it would be wise to realise that there will be some years of low, or even negative capital growth. In these years, it would be difficult to obtain loans to fund your negative cash flow.

I find that valuers are extremely conservative, and will not automatically increase my property's value annually by X amount just because that is what is expected historically!!

Regards Jason.

 

[landlubber]

The strategy is not as aggressive as it may appear. The "ability to come up with cash" is dealt with simply by having the appropriate LOCs in place. In fact they are better than cash per-se ....they are "no-tax payable" cash.

What the value of the IPs actually "do" year to year is less important then "knowing when to have them re-valued" and hence re-setting your LOC's. If the IP dips in value after you have your LOC the bank doesn't take any action. ( I've actually known banks to discard a poor valuation and conitnue to use the "older" (higher) valuation.) But, overall, you are correct the IPs MUST generally increase in value ...but if you DON't believe that your IPs WILL increase in value best to get out of this game NOW. If you think you're going to retire and live off rents..better get used to going hungry or you've got a REAL different XL spread sheet to me.

Valuers. Always (1) know when to revalue ..prices must have risen (2) deal DIRECT with the valuer and (3) you have to basically do their job for them if you want a favourable outcome.

LL

 

[jingo]

The strategy is not as aggressive as it may appear. The "ability to come up with cash" is dealt with simply by having the appropriate LOCs in place. In fact they are better than cash per-se ....they are "no-tax payable" cash.

Whilst the strategy may be tax free, remember that you are paying interest on the LOC!!

What the value of the IPs actually "do" year to year is less important then "knowing when to have them re-valued" and hence re-setting your LOC's. If the IP dips in value after you have your LOC the bank doesn't take any action. ( I've actually known banks to discard a poor valuation and conitnue to use the "older" (higher) valuation.)

Yes, this is true. It is possible to borrow against the equity in "the good years", and establish your buffer for the following years.

But, overall, you are correct the IPs MUST generally increase in value ...but if you DON't believe that your IPs WILL increase in value best to get out of this game NOW.

Lol!!! They will increase in value - but perhaps not as consistently as I would like, and need if I was going to capitalize interest as a general strategy to meet the total holding costs of my portfolio. (At this stage, anyway!).

If you think you're going to retire and live off rents..better get used to going hungry or you've got a REAL different XL spread sheet to me. .

Don't believe I actually mentioned my exact strategy in my post. Just that I wasn't too fond of capitalizing interest at this stage in my investment journey!

Valuers. Always (1) know when to revalue ..prices must have risen (2) deal DIRECT with the valuer and (3) you have to basically do their job for them if you want a favourable outcome.

LL

From personal experience, and from sources within the finance industry, I understand that valuers are not so easily influenced by the homework that investors may provide them with their intention of the valuer providing a high valuation.

Perhaps your experience has been different - congratulations. Would you be able to share a few more of your tips so that we can learn the tricks that you have employed. (As well as the three that you have provided above).

As with any investment technique, I believe that it makes sense to explore the pros and cons of each strategy. As has been mentioned earlier, a new investor totally relying on capitalizing interest to meet their holding costs is bound to come unstuck fairly quickly!

For those with a larger asset base, the strategy can work.

Just as a closing comment - obviously SS is very pro IP's. It sometimes pays to take off the Rose Coloured Glasses - just for a moment, and view each technique objectively.

Regards Jason.

 

[Melbear]

Mate that is fine, but I hope you haven't based your plan on "conservatively earning 24% pa". Sure might happen some years, but if your expecting that every year, or even that as an average, then you're likely to be rather disappointed. That is the main risk with funding debt with debt (especially if taken to the limit) - expected returns on money that are unrealistic or rather volatile.

Nope. At present I am earning much higher than that. I only need to earn more than the bank interest rate to give me some spare money towards the other expenses. That's achievable in even not so good years. At that point I'll just have to use up some of the buffer I've created in the good years, and ensure that rents are continually raised in line with market to reduce the shortfall that I must fund.

Either that or I can just not invest that money, and use it to fund my expenses for a while anyway.

 

[landlubber]

Yes you are paying interest on the LOC and further, that interest is compounding ..... but so is the value of your IPs and (normally) at a higher rate % and on a greater $$ amount .....so ...in general...as long as your LVR is conservative enough this is not a problem.

The IPs don't have to go up each year nor do they have to go up consistently. In the example I gave previously a $5m portfolio even at 70% LVR would have available a $500K LOC to "ride out" any years with no growth/ high interest rates etc etc . Please do some "for instances" for yourself .....

Valuers shouldn't be expected to provide high valuations but they should be expected to deliver realistic valuations. A recent edition of API mag. gave a great article on tips/advice how to get realistic valuations. It was quite factual IMO.

SSs is all about IPs. It's provided free by the Somers for our benefit. I for one am most grateful for that.

LL

 

[jingo]

Yes you are paying interest on the LOC and further, that interest is compounding ..... but so is the value of your IPs and (normally) at a higher rate % and on a greater $$ amount .....so ...in general...as long as your LVR is conservative enough this is not a problem.

Yes, this makes sense.

The IPs don't have to go up each year nor do they have to go up consistently. In the example I gave previously a $5m portfolio even at 70% LVR would have available a $500K LOC to "ride out" any years with no growth/ high interest rates etc etc . Please do some "for instances" for yourself .....

This also makes sense. With a substantial asset base,and a conservative LVR, the strategy will most likely work.

Valuers shouldn't be expected to provide high valuations but they should be expected to deliver realistic valuations. A recent edition of API mag. gave a great article on tips/advice how to get realistic valuations. It was quite factual IMO.

I have found that valuers will give very conservative valuations - especially in today's current economic climate.

SSs is all about IPs. It's provided free by the Somers for our benefit. I for one am most grateful for that.

LL

Yes, I too am grateful. I continually learn something new each day from this site.

However, as with any information provided it pays to do a lot of due diligence before deciding to implement a strategy such as capitalizing interest! In the case of capitalizing interest, it really is a case of deciding whether one's individual circumstance (ie asset base, etc) is able to support such a strategy long term. I for one (and perhaps I am overly conservative), would prefer to use other methods to support my cashflow requirements.

Of course, I am only speaking from my own perspective. But I think it is crucial to emphasize that the strategy of capitalizing interest may not be appropriate to everyone!


Regards Jason.