Common misconceptions about investing in property: Part 2
This month I want to follow on from last month’s ABC of Investing with more common misconceptions around borrowing money for investing and chasing high yields so that more budding investors understand how to start investing in an easy, stress free and low-risk way.
Misconception 5: Avoid paying LMI at all costs
Many budding investors decide to use a 20% deposit just so they can avoid paying Lender’s Mortgage Insurance (LMI) in the belief avoiding paying this premium is saving them money. However, experienced investors look at LMI differently and see it as just a cost of doing business. That 20% deposit may mean you can leverage into two properties by using 10% deposits only. By accepting LMI investors can afford to stretch their cash or equity further and buy more property using other people’s money (OPM) ie, the banks to achieve their goals sooner. They look for banks that capitalise the LMI into the loan (so they end up with a loan of approx. 92%), and as these loan costs are tax deductible they are saving money as well!
Misconception 6: Borrowing 100% or more from the banks is best
A good mortgage broker will assess your borrowing capacity and also help you set up the best loan structure for you. When you have other property (eg your own home) with potential equity, banks can offer to finance 100% or more using your own home or other property as security.
This is called cross-collateralisation. Many investors jump at this option because it seems the easiest, as the banks lend you all funds for the new investment property including the stamp duty and legal costs. How nice of the bank!
However having all your loans “crossed” together may limit your ability to continue growing your portfolio in the future, and leaves you with no buffer for running everyday property expenses. When I started investing I preferred the option of utilising my equity in a different way and set up an offset account (you could also use a line of credit account) and I shared the love around by using many different banks for my investment loans.
This way I avoided having my home and my properties secured together. It allowed me to claim the interest as tax deductions, it left me with a buffer in my offset account to cover the everyday expenses and allowed me to sleep at night! Most importantly, I was able to grow my portfolio faster.
Misconception 7: Chasing highyielding property to get the best cashflow outcomes
As an investor we all want to have a property that pays for itself or in investing terms, property that gives a positive cashflow outcome. I still find that many investors equate high rental yields (eg 8%+) as a guaranteed way to achieve a positive cashf low outcome. However, this may not always be the case as the gross rental yield does not tell the whole story.
The net cashflow after all expenses are taken into account can result in a negative cashflow outcome, particularly if the property is older without any noncash deductions (eg depreciation) and if a realistic maintenance and repair budget is not allowed for. Many investors get a nasty surprise when one major repair takes up all their expected cashflow for the year.
I have found that there is an easier way to achieve a positive cashflow outcome. If you select newer properties that have significant depreciation allowances for up to 40 years, that are less likely to have maintenance and repairs in the first 10 years, they will give you maximum tax deductions and a big tax refund cheque as a second source of income to supplement the rent. Even with yields from 5%-6% your property can have a positive cashflow outcome.
So not only have you more properties to choose from in the market, you can end up with more cash in your pocket and forget about chasing only high-yielding property. Of course you do want to add potential for capital growth to your property selection criteria.
Yields alone will not give you the passive income you may desire!