Futureproofing Your Home & Investment Portfolio – Mortgage Mastery & Property Planning Problem Solving (Ep. 222)

2.14 – Mike opens with NIck’s question about a totally offset PPOR loan, dreams of building a portfolio, and some cash belonging to his parents sitting against the home loan.

12.45 – Mike quizzes Dave about his suggestions for our young family to potentially set their principle and interest loan to interest only.

20.26 – Dave talks about some of the risks that long-term thinkers can sometimes face when they take on too many investment properties in the early days, and then struggle to fund a family home.

24.34 – Cate shares a hint of next week’s show

25.16 – A sneak peak into next week’s show

25.55 – Mike opens Jess’s listener question about how to engineer their family home adventure, while managing an existing portfolio

30.28 – Dave overviews Jess and George’s scenario and he talks about postponing the move to the future family home

36.48 – Dave talks through some of the negatives associated with renovating immediately

39.09 – Mike breaks down the available options and Cate marvels that the listeners have received three, broadly ranging opinions from each of the Trio members.

44.50 – And our gold nuggets!

Show notes:

Listener Question 1 – Hi Dave, Cate & Mike – love the show and have been burning through your podcast backlog after discovering it a couple of months ago. I’ve listened to about 100 episodes now and have learned some great tips, particularly from your case study series. My wife and I have quite a unique scenario and we’re weighing up our next purchase and would love your help. Perhaps our scenario could become a useful case study for other listeners to learn from also.  
 
Our PPOR home loan is fully offset but we plan to turn it into an investment property in the future. We are fortunate enough to have both our own savings in the offset account as well as some funds parked there by a parent, so don’t pay any interest. The loan repayments are P&I, therefore each month we are paying a big chunk of the principal owing, but only stick to the minimum repayment amount. After listening to so many episodes that mention preserving tax deductibility, I’m questioning whether this is the right strategy as there might be the potential to switch these loan repayments to IO, therefore minimising the monthly repayment amount and preserving as much future deductibility as possible. This also would help our cashflow/savings because we’d have more surplus cash each month to put towards our next purchase.  

On the other hand, the more prinicpal that is paid off, the more borrowing capacity we may have for future lending if we refinance and do an equity release. There is also the chance that the parent takes their money out of the offset to use in the future and we’d therefore need to start paying interest again, so the lower the amount owing at that time, the better off we’ll be. 

The Trio congratulates them on their achievement, particularly given their ages and the fact that they have a baby too. They have been cognisant of their cashflows and they have saved and managed their money superbly.

One twist to the story, however is that some of the total offset funds belong to Nick’s parents. While it helps with the interest repayments, the Trio talk about some of the challenges and risks that can result from arrangements like this.

From personal interest repayment arrangements to obligations and burdens that can be created, Cate talks through the emotional difficulties that some can face. And if the parents decide to ask for the money back, will this negatively impact the couple’s future plans.

Dave points out the importance of flagging a loan from parents as a sum that could be repayable on demand. He also unpacks the way that lenders view such arrangements, and maintains a pragmatic view for our listeners.

Nick also asks the Trio about converting their principle and interest rate to interest only… a perfect segue for Dave to discuss the merits of an interest only loan arrangement for disciplined investors.

Preservation of the loan balance leads to higher tax deductions, greater control of their money, cash buffers to go towards the future home, and enhanced choice going forward. It’s easy, but it’s not simple and so many people miss this incredible strategy. But…. it’s only for disciplined investors.

They are currently 100% offset, so although the interest rate is a little higher on interest only loans, I would suggest moving to I/O because you are preserving the loan balance, whereas P&I is reducing the loan balance.

Why take this action:

1. By preserving the loan balance, you will have more tax deductions when you turn this property into an investment.
2. You will also have a bigger cash buffer to go towards the future home
   1. because you are saving more money each month
   2. meaning you will need to borrow less to purchase the home
   3. and therefore, you will have less non-deductible or bad debt on the future home
3. In terms of it impacting your borrowing capacity, this is basically netted off because:
   1. Yes, the existing loan will be greater, because you haven’t paid off the principal – let’s call it $50,000 that you haven’t paid off
   2. But that $50,000, is now in your savings, and can be used to lower the amount you need to borrow for the future home
   3. So, your loan amount for the future home, will be $50,000 less than otherwise required
   4. In essence, your end position will be very similar so any impact on borrowing capacity will be nil, or negligible

The Trio’s finale for Nick and his wife relates to their question about when and where they should buy.

Cate says, “It’s a very ambitious goal, and don’t let me separate ambition from reality. I think that the two can go hand in hand when you’ve got a great plan.”

Dave reinforces Cate’s point about the importance of planning and he offers some good questions for them to consider.

As part of the refinance of your loan to I/O, and find out what your borrowing capacity is if you were to purchase a new home.

You might discover that based on what you want from a home, you are going to need to sell or at least understand how difficult it is to purchase the 3^rd investment, and then a home in 3-5 years.

You could also pay to model out a Property Plan, and multiple scenarios and pathways to reinforce:

1. how achievable this plan is,
2. how long you might have to wait to purchase the long term home, and
3. if that changes your thinking regarding which property comes next.

Either way you will have more certainty around the way forward.

If it turns out that your next purchase should be a home, you could also be able to begin the process of determing your preferred location, suburbs, property type and track sale prices to ensure you know your market inside out so that when you are ready to buy, you can do so with great confidence.

I find that most people start this phase of the market analysis far too late, and it is a big reason many people take 6 – 24 months to purchase after getting the intial pre-approval.

1. I always encourage our clients to begin this process of tracking the sales, visiting properties and locations as early as possible so they can start to become clear on what they want to purchase a home ahead of time.
2. This often means the adjustment phase of realising their initial understanding of where value lies, and potential compromises need to be made is done in advance of when they are actually serious about purchasing.
3. What this often does also, is brings forward the decision-making process and people get an AIP and purchase faster because they take a full holistic approach to purchasing and manage it like the serious project that it is, just as if they were managing a project in their workplace or business.

Obviously, you need to factor in that the parents money could be taken away at any given time, by the sounds of it, into all your planning – this is where modelling different scenarios could also be useful for you in our Property Planning software that you have lifetime access to.

A Property Plan may also be helpful for you with a specific focus on the key numbers for your Next Purchase which is something we can assist you with also if that isn’t clear

Mortgage Strategy Advice

• Make sure you plan your loan approval and purchasing while you are both are working and your incomes look the strongest on paper.
• With your wife being self-employed, lenders will normally look at the last two years completed tax returns.
  • However, if it has ticked over into the new calendar year, they will generally require the last years’ tax return to be completed so you need to be mindful of this and what each years returns show.
  • For example, if last years was really good, the year before not as good, some lenders will just go off the previous year, some will take an average of both years.
  • Or if the year just finished wasn’t as good, then you want to aim to get approved and purchase of the two years prior subject to where your borrowing capacity sits.
• And be mindful that you want to purchase during that calendar year, or the lender may require you to provide the most recent years returns that are weaker.

Obviously, this is all prefaced by you should only borrow based on what you can comfortably afford with a plan for rate rises of 2-3%, and setting goals of your preferred cash savings buffer and monthly cash flow buffer as ultimately those two numbers should drive your purchase price.

How much you want in the bank at settlement to feel secure

How much you want to be able to save each month after all your expenses

Side question… if you do make a mistake and pay down too much of a loan before you plan on switching from PPOR to an investment, couldn’t you just refinance back up to 80% LVR in order to again maximise the tax deductibility of the loan interest?

Dave and Cate shed light on “The Purpose Test”, and the rationale that the ATO apply when it comes to deductable debt.

A lot of people think you can just refinance and redraw the money back up to 80%, then claiming it as a tax deduction, but you cannot do this.

1. You only get one chance to borrow to purchase an asset and that is when you buy it.
2. If you redraw your money up to 80%, where will that money go?
3. If you offset the same loan there is no benefit of redrawing it, so in most cases people will then use it to fund the next purchase, which is often the new home or even renovating an existing home.
4. But the home isn’t deductible.
5. Therefore, this new portion of the loan would be non-deductible, and the other portion deductible.
6. This can make the deductible portion less efficient because any repayments would be equally apportioned to the deductible and non-deductible debt from an interest claiming tax perspective.
7. If you were to claim the interest, even though that new money redrawn up to 80% wasn’t used to purchase the property initially, you would be breaking the law, and if audited would have to repay the interest and possibly face a fine.

A lot of people think you can do this and claim the interest, but that is confusing the loan account that was used to fund the investment, with when you borrow the money, and what it is used for.

This is often called the Purpose Test. What was the Purpose of the money.

Phases –

1. Loan initially was borrowed to pay for the investment property. Lets say balance is $800k.
2. You then pay down loan over time. Let’s say down to $400k
3. Usually years later, you refinance and redraw the loan and essentially borrow new money, and then use that new money to pay for the new home.

$800k loan again, but $400k for initial purchase, $400k redraw/refinance which is then used to fund new home.

Plus the new loan you get to pay for the remainder of the cost of the new home.

Listener Question 2 – Long-time listener, first time question. Have used Ryan at Property Planning Australia for our last purchase (thanks – was very good). We’ll be coming back his way for future ones.

We have 3 properties; 
 
Investment property – Parkside: Husband owns 100%. We moved out in 2017 when second child was near to get a bigger property. Currently rented for $525 pw and about $200k owning on interest only loan. Valued at about $1m.  

Current PPR – Glandore. Paid, $735k now worth about $1.2m – owing $680k on P&I loan. Have $200k in offset. 
 
We wanted to move into the suburb and property we want to raise our family prompted by significant road works about to happen  near our Glandore property.  
 
We purchased Torrens Park for $2m in May 2022. We rented it out to allow us time to plan for renovations we’d like to make and save up a bit more. However, 14 Interest Rate rises later we haven’t been able to save as much as we hoped. This property is rented out for $1050 pw and provides significant negative gearing benefits.  
 
We would like to move into the Torrent Park property next year when the lease is up. We plan to do a modest renovation at about $150k to the upstairs of the house, then would like to undertake a larger renovation about $1m in the next 2-4yrs. Question… which options provide the best outcome in the long run and also for now given the higher interest rates; 
 
1. Should we sell Glandore pay no capital gains and place towards to Torrens Park offset. approx. $500k. 
 
2. Should we sell Parkside – Husband owns a business so we can reduce the Captial gains via tax brackets – approx. think this would bring about $700k towards Torrens Park offset.  
 
3. Hold both properties, wait for further capital gains and sell later to pay down more of Torrens Park.  
 
Our cash flow would allow us to do this, however we’d have only $50k in offset which makes us nervous. Ultimately, we’d like to keep one or two investment properties for retirement.  

Cate speaks about the importance of happiness when it comes to the family home, whereas Dave talks about the need to consider postponing the move into their family home. He speaks about setting up the goals in stages, alongside a robust financial plan, and Dave spells out each of the five important stages.

Cate shares two real life experiences for our listeners that involve a two and three step renovation that moderates the expenditure and the risk of overcapitalisation.

Dave shares from a financial perspective, what would be the best course of action – our listener would be best off postponing moving into the long-term home until such a time that you can hold all three properties.

This would allow your equity and savings to grow in all three, your personal and rental income to increase, and your debt or net debt after offset to reduce until you are in a position that you can complete the renovations in full and hold all three.

However, it appears that the pull of Lifestyle preferences is outweighing the pure financial return outcome (as it so often does). This is a very, very common pattern.

• Stage 1 – Begin aggressively accumulating property for wealth creation.
• Stage 2 – Plan for and possibly start a family.
• Stage 3 – Lifestyle and the family home becomes the top priority
• Stage 4 – Compromises are made, property is sold to optimise the family home and lifestyle outcome.
• Stage 5 – Once the long term family home is bedded down and you are back into a strong enough financial position, focus on investment returns once more.

However, if they are resigned to selling a property, Dave has the following advice: Just doing the maths, you have renovation expenses of around $1,150,000.

And from my experience this could increase, especially if you wait 2-5 years, when it might end up being anywhere from $1.2m to $1.5m.

If we do the numbers on each property –

Sell Parkside – You get around $800k or so less any tax.

1. Husband owns 100%.
2. We moved out in 2017 when second child was near to get a bigger property.
3. Currently rented for $525 pw and
4. about $200k owing on interest only loan.
5. Valued at about $1m.

Sell Glandore – Your current home and significant public works get around $500k,

1. Paid, $735k now worth about $1.2m – owing $680k on P&I loan.
2. Have $200k in offset.
3. Provides $500k from sale.

The key considerations –

1. Working out if you have to sell Parkside to complete the renovation, or if you can get by with selling Glandore, despite not getting as much cash from the sale.
2. The advantage of selling Glandore is that you maintain more equity across your portfolio given you have $800k of equity on Parkside, and only $520k on Glandore.
3. Which property is the better quality asset – sounds like Glandore might have its issues with the public works.
4. Given both have been a PPOR, understanding the tax implications of selling Parkside and how that impacts the cash position is something you should do, but this may not be a lot given it was the PPR for a period of time so the CGT will only proportionate to the period it was an investment.

Scenario mapping on selling Glandore

If you sell Glandore you have around $500k from the sale and the $200k you have in offset.

So this means that you will have $650 – 700k cash to go towards a renovation of $1m to $1.2m, although it may be more?

Therefore, can will need to borrow $350k to $550k at least.

And really, given your debt position, you run a business and have young children, I think that I would like to see you with a buffer of at least $200k that you currently have maintained.

1. So that really means needing to borrow $550k to $750k.
   1. Keeping in mind you will be paying out the $680k loan on Glandale so you overall debt position would remain the same, but you would be losing some rent.
   2. You might even be able to sell and keep that loan and just have it secured against the new home in Torrens and the Parkside property which will be worth $3m in combo x 80% = $2.4m.

Your debt is $200k on Parkside,

If you kept the loan open for the $680k if possible,

That would mean as long as the Torrens loan is under $1.52m you have the equity.

1. Then effectively all the funds from the sale can offset the home loan on the house you move into and be drawn down to fund the renovation.
2. The benefit of using your own cash is you have complete control of the construction phase and don’t rely on the bank.

Timing considerations 

Once you decide the pathway, it is worth asking yourself if you should bite the bullet now and sell and renovate sooner, while you live in one of the current properties.

Pros

• Could this save you the $150k you plan to spend on the first smaller renovation?
• With inflation, could this mean the full reno is cheaper than if you waited 2-5 years?
• Could there be less personal upheaval and hassle with living arrangements with one renovation rather than two?
• Could this provide a longer period of stability in the full renovation or built new house

Cons

• You might lose out on extra capital growth and equity built up over that period of 2-5 years
• Your overall financial position could be improved over the 2-5 years to mean that the step to complete the full build is less financially onerous.