Interest Only Investment Property Funding Strategy - Hidden Risks

Written by Michael McAlary

A few key aspects to consider about when buying an investment property:

  • Location
  • Strong rental income growth
  • Rentability and continued occupancy
  • Long term capital growth
  • Re-development opportunities
  • Likely maintenance costs
  • Ongoing capital improvements
  • Portfolio diversification
  • Tax effectiveness
  • A popular strategy to finance the acquisition of a property is to take out an interest only investment loan. This strategy is based on the premise that the property value at the end of the loan term will be greater than the loan balance with the surplus being a profit before any Capital Gains Tax (CGT).

    This Interest Only loan strategy is risky for the following reasons:

    Negative Gearing

    Negative gearing is when income generated by the investment property doesn’t cover the costs, e.g. interest, fees, rates, etc., and the loss each year can be claimed as a tax deduction.

    With negative gearing you:

  • Must fund the cost from the other income sources until the property is sold
  • Can only make a profit if there is a capital gain that takes into account the ongoing cost over the life of the loan.
  • Negative gearing works best in a low tax free threshold and high marginal tax rate environment. However, from 1 July 2013 the Australian taxation regime moved to a high tax free threshold and lower marginal tax rate situation. This makes negative gearing less attractive than before

    Property Prices Fluctuate

    This strategy assumes that there will be a capital gain when the property is sold. This may not necessarily be the case as property prices generally fluctuate with economic cycles. Notably, from 1990-1992 and again between 2009-2011, residential property prices fell between 10% and 30% depending on the location.

    In the long run, if you wish to sell your property you must time your sale to coincide with the property market peaking so as to maximize your capital gain. Timing your market entry and exit so as to maximize your financial position is for most a matter of luck.

    Serviceability

    Interest only loans normally revert to principal and interest standard rate loans after 5 years. This means that you have to repay the full principal amount over a shorter term and if your personal circumstances change, the shorter term and greater instalment may place you under financial stress.

    Many borrowers keep rolling their interest only facilities every 5 years the effect of this is to increase risk, i.e. you are pushing your “risk” out into the future when from a debt management perspective you may wish to reduce it.

    Taxes and Levies

    Land tax and car pacing levies for city properties are costs that many property investors over look. In the Sydney CBD the car spacing levy on a strata commercial property is approximately $2,000 per annum.

    WealthMaker Financial Services can help you with your investment property strategy. Call us on (02) 9233-1111 for an obligation free appointment.

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