Show notes – Investment Borrowing Masterclass – Maximise Tax Deductions and Advanced Mortgage Strategies for Long-Term Wealth Creation (Ep. 250)

For today’s episode, the Trio are diving into the sophisticated world of investment borrowing and they’ll unpack the nuances of leveraging borrowed funds to not just acquire investment properties, but also to optimise the financial structure surrounding your investment to legally optimise deductions.

Despite accountants being tax expertes, they are not mortgage strategists and so it is important that investors understand these strategies and are able to implement them with their strategic mortgage broker.

Whether our listeners are seasoned investors or just starting out, today’s masterclass with Dave will equip buyers with the insights to navigate the complex landscape of investment borrowing.

Dave launches into the ep with the first tip about investment borrowing. But he confuses Mike about good debt versus bad debt. Cate defines good debt, bad debt and terrible debt!

1. What’s the first tip that you have for our listeners about investment borrowing?

Tip number one, and this might be stating the obvious for some people, is that you should borrow as much of all the purchase costs associated with purchasing an investment property as you.

IF

• you haven’t paid off your home loan,
• still have non-deductible debt to pay off
• Or plan to borrow to purchase a home, holiday house or complete a home renovation or any other major non-deductible expense into future.

Some people, for example, who have a large sum of cash reserves or cash buffer up their sleeve may not think to borrow funds for an investment purchase if they have some cash to fund part or all of the purchase, and they may mistakenly opt to reduce the investment loan for the purchase instead of using those funds to pay down or offset the non-deductible debt such as a home,

We want to keep cash for the home loan because it is effectively cheaper debt because there are no tax deductions, even though the interest rate is often lower than that of an investment loan which can confuse people. That is as long as the investment property is being purchased by someone earning an income generally above the tax free threshold.

2. So would you say that people should try to borrow the full purchase price plus all purchase costs if they can for an investment purchase?

Generally speaking, yes

If you have equity in other property, ideally you borrow the full investment price plus costs

OR as much of it as possible to optimise your tax deductions and keep your surplus savings for reducing the interest on the home loan.

Also ideally borrow:

• The deposit to ensure it is claimable – technically if you pay for it in cash you shouldn’t claim it the interest, even if you pay yourself back later on from the loan when it settle.

What you should do is pay for the deposit from a loan

• And borrow the purchase costs – like stamp duty, transfer fees, solicitor fees, buyer’s agents fees

This might mean that on the purchase, you go up to 106% of the pruchase price EG the full purchase price plus the costs that often add up to 6% of the price or more if using a Buyer’s Advocate

3. How can someone borrow the full purchase price plus all stamp duty, buyers agents and other associated purchasing costs EG 106% LVR?

You need have 26% of the value of the investment property available in equity, generally up to 80% of an existing property or across your property portfolio, and use the available equity in properties that you already own, to borrow against.

Example

• Eg: you bought a home for $1,000,000 and got a loan at 80%, and borrowed $800,000.
• Over time, you paid the loan down to $600,000 and the property grew in value to $1.2M.
• You can borrow again up to 80% of the $1.2M value – so the maximum amount you can borrow against the property is $960,000.
• Your existing loan is $600,000 – so $960,000 take $600,000 – you have $360,000 equity that you can access.
• Now, let’s say you plan to purchase an investment to the value of $800,000 purchase price
• To borrow 106% LVR you x $800,000 by 1.06 = $848,000 loan that you need to cover the purchase price plus costs.
• At 80% LVR, the loan that you can get against the investment of $800,000 is $640,000 – so that falls $208,000 short of the $848,000 loan that you need.
• But this $208,000 you can access from the $360,000 in equity you have in your home.

For more detail on how to access equity, I would suggest listening to ep 230: Equity Unleashed: Property Planning & Borrowing for Renovations & Wealth Creation – which takes you through the ins and outs of how to arrange this.

If you do not have a property portfolio and you are a first-time buyer, we have also helped people achieve a 106% LVR purchase where the purchaser’s parents put up a security guarantee. Similar concept, but instead of using equity that you’ve built up in a property that you own, you use the equity in your parent’s property. Without this the most you can borrow is likely to be 90% – 97%

4. Being able to borrow the full purchase price plus costs is a big advantage. Is there any reason to set up the investment loan limit for more than the full purchase price plus costs and what are some of the logistics around managing the loan drawdown and settlement?

Yes, depending on how much equity you have available to use, you could set up the loan limit to be in excess of the total purchase costs.

For example the loan could be set up to be $20k, $50k or more above what you need.

You can then borrow additional funds from redraw to pay for your ongoing investment expenses that are deductible.

Eg:

1. Property manager fees
2. Maintenance costs
3. Rates and water
4. Depreciation schedule

Ther reason you do this is so that ALL your surplus savings are used to pay down or offset your non-deductible debt or home loan.

When you set up this kind of facility and settle on the investment property, you need to ensure that these surplus funds are deposited back into the loan account – so that balance of the loan is what you paid for the property and the remaining purchase costs.

The surplus funds will then show up as redraw – available for you to pull out to pay for these expenses.

The lender will just drawdown the loan in full, and if you ar enot on the ball you will just ahve a larger loan and those funds will be sitting in your offset on your home loan and you may incorrectly claim the wrong interest amount on your investment.

5. What are some other benefits of using equity to fund an investment purchase?

The more equity you can use to borrow, means you use LESS of your own cash reserves which means that –

1. You have more savings reducing the interest on your home loan and paying off you home loan faster
2. You have a bigger buffer and safety net of funds up your sleeve for a rainy day – all the way from your car breaks down to going down to one income for an extended period of time as you start a family.
3. You maximise your tax deductions becuase after tax, the true cost of an investment loan is cheaper than a home loan

6. Should investment debt and non-deductible debt be kept separate and never the twain shall meet?

Yes, absolutely – do not mix deductible and non-deductible debt in the same loan account.

We see this most commonly when people have a lot of redraw built up, perhaps in their home loan.

They’ve worked hard to pay the balance down and they have $200,000 in redraw sitting in their home loan, which they then pull out to use on their investment purchase.

Now you have a loan which is mixed for owner occupier and investment purposes, and will be a nightmare for your accountant when they go to do your tax return – as only a portion of the interest paid on that loan is deductible and a portion not.

If you have 80% of the loan non-deductible and 20% deductible, each repayment you make 20% will be apportioned to reducing the deductible debt and this is –

1. Costing you tax deduction over the long run
2. Slowing down how rapidly you pay off your home loan or non-deductible debt because not all the principal is going solely towards paying down your home loan.

So always keep your good and bad debt separate.

7. What about the repayment strategy, how might a strategy for investment borrowing differ from home borrowing?

Listen to Ep 239 on Why you should pay off your home loan first, and Ep 181 on the mortgage and wealth creation strategies linked to your loan repayment strategy.

1. P&I v I/O –

As a general rule, you would pay

• Pay p&I on home loan to pay off first
• Pay interest only on investment to optimize deductions.

What this means in reality is optimize the true cost of the interest on the debt is less than that of the home loan when you factor in the tax deduction from the interest rate.

2. Offset accounts – Offset your home loan debt first, before you offset your investment debt.

We’ve actually done a whole episode Ep 239 – Optimising Offset Accounts – Why You Should Pay Off Your Home Loan First & Other Mortgage Strategies to Create Wealth & Maximise Retirement)

3. Fixed rates – as fixed rate loans rarely allow an offset account to be linked to them and when they do, it’s not 100% offset, some people might choose to go variable on their home loan debt (with offset account attached) and fix their investment loans (no offset)

However, there are many and various considerations which go into whether you should fix or not.

And then if you do decide to fix, how much of the debt do you fix?

Luckily, we’ve also done an episode on repayment strategy, so a good starting point to understand the considerations better would be to listen to that…

Ep 181 – Interest only vs Principal & Interest – Why working through the different considerations could add millions to your nest egg at retirement

And then of course, I would recommend to seek personalised advice based on your own situation by talking this through with your strategic mortgage broker.

8. Are there any tricky scenarios which might fall outside of that general rule of paying interest only on investment and P&I on your home loan?

Yes, we get a couple of scenarios that are a little bit out of the ordinary.

And these can be incredibly complex to work through, such that even mortgage professionals can struggle to wrap their heads around the logic and calculations.

Ultimately, the best option for you will depend on your individual circumstances. So, if you have one of these curly questions, I would suggest talking it through with your strategic mortgage broker.

However, there are two scenarios that I can share which come to mind.

Scenario 1 – Where the Home loan is 100% offset and paying P&I and you’re looking to borrow to purchase an investment property

In this case we do I/O on the home loan because it’s fully offset, so the repayments will be $0 on interest only and P&I on the investment loan IF they will not use some of the offset or borrow more non-deductible debt into the future AND as long as they qualify for servicing etc because service less on I/O

Scenario 2 – Occasionally there are people who have investment debt only

The advice here will depend on whether the person intends to buy a home in the future and will need to borrow non-deductible debt in order to do that. Eg:

1. they have a home that has no debt on it, but will need to borrow in order to upgrade; OR
2. they don’t have a home, they are rentvestors, but intend on buying a home down the track

Essentially, the conundrum faced by people in that boat is they are trying to decide whether to pay P&I now on their investment debt because P&I has a cheaper rate OR pay interest only but at a higher rate. The advice might be to pay interest only on the investment for two reasons:

1. Build up your available funds faster – the IO repayments are lower, which means you can save MORE
   1. Then when you purchase your home, you will have more of your own funds in cash savings to use towards the purchase, which means that the amount of your home loan will be lower, which means you will have less non-deductible debt.
   2. BUT you need to be diligent with this, and ensure you are ferreting away the savings to use towards the home.
2. Maximise your tax deductions on the investment loan – yes, the rate is higher, but that just means that your tax deductions are higher as wel

9. What advice can you give to our listeners who are planning to upgrade their home and they would like to keep their old home as an investment property, rather than sell?

Preserve the balance of your home loan if you plan to upgrade and keep your old home as an investment property.

This means:

• Paying interest only on your home loan (if you qualify)
• Paying the minimum P&I repayment if you don’t qualify for interest only – so you are reducing the balance by the least amount possible – do not make additional repayments

Why:

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. Any impacts to your borrowing capacity will be 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

Gold Nuggets:

Dave Johnston’s gold nugget: “If you’re getting strategic mortgage advice, make notes.” The retention rate of detailed information is often compromised, and it’s important for borrowers to be clear on their mortgage strategy and set up.

If you are thinking of making any changes to your mortgages, run them by your strategic mortgage broker first. Each time you take money out of redraw or go to refi or set up a new loan take the time to get the structure and strategy right!

We have had plenty of instances where we’ve taken a lot of care to set up someone’s mortgage strategy to align with their goals and optimise wealth creation.

But as with these things, people forget.

Apparently we forget 50% of what we hear within 24 hours and 90% within a week,.

With mortgage strategy our lived experience is that  people don’t always remember why their mortgages were set up the way that they were set up.

Then we come to learn that someone has drawn money from their investment loan to fund some home renovations, and as you know, home renovations are not tax deductible and then it becomes a mess for them and their accountant to sort out.

Or some bright spark at the bank has told the client that they would save more money if they changed the offset account linkages so the offset is linked to their investment loan instead of the home loan. The client thinks great!

So, the client then does this and now they are missing out on tax deductions, which in the end, save you more money. And this is all because the bank staff member does not understand mortgage strategy.

So definitely, if you’ve got something on your mind, have a chat with your strategic mortgage broker about your plans before diving in.

You have nothing to lose – they will either stop you from making a bad mistake or confirm that your thinking is correct, or raise some points that you haven’t considered, or even give you some options that you weren’t even aware of.

Take good notes of why you have your structure the way you do and/or ask for that to be sent to you by your Strategic Mortgage Broker and their team

Cate Bakos’s gold nugget: Not being afraid of good debt is important. But being aware of the worst kind of debt is also very important too. Unsecured, expensive and short-amortised debt can be problematic. “I highly recommend you talk to a strategic mortgage advisor if you have that kind of debt.”

Mike Mortlock’s gold nugget: Number one rule – investment debt is what you want to maximise, and home loan debt should be minimised.