Category: Financial

Is compound interest the eighth wonder of the world?

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. – Albert Einstein

Finance is leverage in the financial world. Getting the balance right is absolutely crucial when you are growing a property portfolio. Having your portfolio too highly geared leaves you nowhere to go if something goes wrong and conversely not using finance to leverage means you most likely find extremely difficult to build a property portfolio. Compound interest is a double edged sword, as leverage, it can quickly grow a property portfolio or if it is misused it can quickly destroy a property portfolio. A good analogy is a knife, a knife in the hand of a surgeon can be lifesaving, a knife in the hand of a thug can be life threatening. The same for compound interest, as Albert Einstein says he who understands it earns it, he who doesn’t pay for it. Having a good understanding of compound interest will help you use it a leverage tool to grow a property portfolio.

So what is Compound Interest? Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. In the case of a loan, interest is calculated on a daily basis and charged the loan every month. As long as you are paying more than the interest charged each month you will be paying off the principal. Paying more and paying frequently will see the loan term shorter, if you stop paying then you will end up with interest being charged on top of interest and can quickly derail a loan.

A common question that I often get asked is how do I get started borrowing money for an investment property? To start buying your first property requires a deposit. A good number of lenders will lend up to 95% of the property value. There is an additional cost for people who borrow over 80 % of the property value this cost is known as lenders mortgage insurance. If you are borrowing 95% of the value of the property, the mortgage insurance cost will be in the vicinity of about 2.5% – 3.5% of the borrowing cost. Some lenders will capitalise this to the loan which will mean you have effectively borrowed 97.5% – 98.5% of the value of the property.

There are pros and cons. In an upward trending market, it gets you in the property market before the property price escalates again. You may find that paying a mortgage could be similar to paying rent and justifies the mortgage insurance costs. This has rung true in recent times with interest rates being so low. Conversely, in a steady or even downward trending market you will have to work hard at paying down the loan as there is no growth to offset the cost and a bigger risk to manage the mortgage. Borrowing at 95% of the value of the property is a great way for a first time home buyer to enter the market. For most home buyers they look at the first home to get out of the renting cycle, it will either be their forever home or they will use the home to upgrade into something bigger down the track. On the other hand, the property investors goal is to build a property portfolio to create financial freedom. Having too many properties too highly geared will create more way more headaches than freedom.

I would strongly recommend if you are starting out on your property investor journey save at least a 10% deposit plus the cost to complete the deal. I can hear some of the arguments now as I say this, there is a school of thought that you use as much of other people’s money when you invest, so you can get into more properties. The mortgage insurance is just a cost of doing business. My response to this school of thought is to keep the end goal in mind, you want financial freedom not headaches.

Having your personal finances in order is about being a good steward of your money, making sure that you are constantly keeping everything in balance. This includes your leveraging.

Happy investing

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The 7 mistakes that property investors make

The seven mistakes apply to any property niche; it does not matter if you are a vendor financier, a landlord a renovator or a developer. The seven mistakes are;

 

  1. Not getting the right advice or worse still taking advice from people with zero experience. How often have you heard a story that goes a lot like this, the uncle three times removed, once owned an investment property and everything that could gone wrong did go wrong. The tenants stopped paying and just before they abandoned the property they trashed it and then as soon as it was repaired it burnt to the ground. Yes, things to go wrong, however if one has seeked some good advice and education on property investment it would become apparent that you can mitigate many risks associated with property investing. For example, you can get landlord insurance that can cover rent default, malicious damage and building insurance in case of fire. It is not all doom and gloom, property investment is a skill and takes the correct advice and education to hone it.

 

  1. Shopping around for finance – it sounds like a good idea but what is really happening is that your credit report is now starting accumulate “footprints” of all the lenders that you have approached. This then impacts the decision of the lender that you finally decide to work with, many loans get refused purely on the basis of too many credit enquiries. Employ an experienced mortgage broker to make enquiries for you that will not impact on your credit report. A mortgage broker has the ability to go in behind the scene and make all the enquires you need without the enquiry being recorded on you your credit report. Obtaining credit has become quite complex, leave it to the professionals do a good job for you.

 

  1. Not correctly structuring finance – Many lenders will “cross collateralise” the properties which means that the collateral from one property is used as collateral to acquire another loan for a property. The impact of having the properties crossed is that the acquisition of more properties becomes quite difficult. You are also at the mercy of the lender that has all your business. If you want to use the equity of your current property to buy an investment property, the best structure is to open up a line of credit for the equity that you wish to tap into. For example, you own a property that is worth $500,000 and you currently owe $300,000 on your home loan and you want $100,000 released so that you can put deposits down and pay closing cost for the new purchase. One of the best structures is to have the loan “split”, $300,000 remains usually as a principal and interest reducing loan, and the split loan is a line of credit loan. That way you have separated the non-deductible debt (debt that cannot claimed as an expense on your tax return) from deductible debt (debt that may be claimed as an expense on your tax return). If you simply “top up” the $300,000 home loan to $400,000 there is no clear line between your non-deductible debt and your deductible debt.

 

  1. Too much debt and not enough debt reduction – All too often people get excited and want to gear or leverage their properties to dangerously high levels without any thought as to how they are going to reduce the debt. The thinking here is that they are hoping the properties will increase in value and eventually payout the debt, but what if the properties do not go up in value? Interest only loans, whilst they are a great tool for growing a property portfolio, there still needs to be some debt reduction component to the overall portfolio. The first debt that needs debt reduction is the non – deductible debt or better known as consumer debt, usually home loan, car loan and credit cards. Refinancing and wrapping up your car loans and credit cards into home loan sounds like a good idea as most people like that the monthly repayment will be reduced. Think about this, if you wrap up your maxed out credit card with last night’s dinner on it you will be paying last night’s dinner back over 30 years! A properly structured debt elimination plan is always a much better choice than just simply wrapping up debt every few years, you will never own you home doing that. It also indicates that you are living beyond your means, and you need to address the amount of spending not cover up the bad habit with constantly rolling up bad debt into your home loan.

 

  1. Using your current bank for all your needs – You may have been a client of a bank since you were 5 years old when your parents set you up with a little bank account to get you in the habit of saving some money. Eventually you grow up and you want to buy your first home so you naturally go to the bank that has your saving account to approach them for a loan. The big mistake here is that no two banks are the same, on the outside looking in they appear to do the same thing. If you are an aspiring property investor you want lenders that can meet some specific criteria on your proposed purchase. You don’t want to be locked in to one banks policy you want flexibility to use different lenders to take advantage of good lending deals.

 

  1. Buying a property on emotion and not the numbers – Emotional buying often does not have a good ending. When buying an investment property, the numbers have to make sense. If you buy the property on the basis that it had a beautiful bathroom and a delightful kitchen, you will more than like pay too much for the property. You are never going to live there so the beautiful bathroom and delightful kitchen should never be the decision trigger. The rent or the yield and the capital required to purchase the property become the most important criteria when buying an investment property. Followed closely by the location, and the infrastructure to support the proposed occupant. The numbers never lie, if the deal does not make sense to you don’t buy it, there will always be another opportunity that comes along that will suit your buying criteria.

 

  1. Fear causing analysis by paralysis – The level of complexity is high when it comes to property investment and the amount of education on various different property investment niches is prolific as are opinions on the best way to make it. Getting clear on your property niche is vital to success. Do something you are going to love. I personally love the vendor finance niche as it involves structuring a deal to give someone a homeownership opportunity. I am definitely not a renovator, the whole idea of ripping up smelly carpet and painting does not excite me one little bit, so I avoid that type of niche. I have complete admiration for people that do it and do it well, the big message here is that you have to love what you do and it will come easily for you. Procrastination usually shows up because the person is either not clear on what they need to do or it is not high on their values list. I often hear “I just need to do more research” before I put in my offers or all the good investment properties have all gone or the timing is not just right. The reality is that these are some really good justifications for not moving forward, just know that when you are in this space the underlying emotion here is fear or as many people say fear is the acronym for False Evidence Appearing Real.

The numbers don’t lie

Buying an investment property is not about guessing if it will make you money or not. Being clear on what type of property niche you are working in and how much you expect the property to make will ensure that the property meets the objective making money. Once you are clear on the specifics of the property it makes communicating with agents a whole lot easier and they can be on the lookout for properties that suit you.

If your sole objective is to reduce your tax and that is the only objective you have, you will lose money, for sure. Many people are sold on the idea of saving tax when they buy an investment property. In order to save on tax, you have to lose money on your property investment. The strategy is known as negative gearing. The Australian Tax Office allows you write off any of the losses you have on your investment property against your personal income. Sounds good but is it really? As an example, let’s say you are earning gross $100,000 annually and your tax rate is 35 cents in the dollar, your tax bill for the year is $35,000. Your investment property loses $10,000 in the financial year. For the calculation of the tax, the $10,000 loss is deducted from your gross income of $100,000, making it $90,000, the tax is then calculated on $90,000 making the tax bill $31,500 instead of $35,000. You meet the objective of “saving tax” of $3,500 however it cost you $6,500 to save $3,500.

This is the crazy part, the property has cost you money, and that money comes out of your pocket. Some people argue that the capital growth of the property will exceed the losses. Sometimes it does and sometimes it doesn’t, at the end of the day this is a hope and pray strategy. All too often I see people with 4 or 5 negatively geared properties because they were sold on the idea of “saving tax”. You only have to have one small thing go wrong and it puts enormous pressure on you personally and can force you into a sale that may not be convenient.

If your objective is to make money, look at a property from its income earning potential versus the capital outlay. I have seen too many investors get caught up with the price of the property instead of looking at the return on the property. They are so focused on the actual price they forget about the return.

You can very easily do a “back of the envelope calculation” that requires finding out what the weekly rent potential is versus the value of the property.  If you want to achieve a 5% return you would look for a property where the rent is the same as the first three digits in the purchase price. For example, $400,000 house rents for $400 per week it is roughly a 5% return. In fact, it is really 5.2% ($400X 52 ÷ $400,000) = 5.2%. Try it – it works! Given that interest rates are at an all-time low it becomes easier to seek a neutral or positive cash flow on the property.

If that same $400,000 property only earned $300 per week it would only be a 3.9% return. If the interest rate on your loan is 4.5% you are in a losing proposition from day one. The good thing about a very simple calculation it allows you to sift through and sort out the properties that you may consider buying.

Saving tax is a very poor reason to buy an investment property. The numbers don’t lie, and you can always rely on them. Understanding the numbers on a property combined with some solid market research should yield you a return that you are seeking. Armed with this information you can sit down with your accountant or financial planner and get the appropriate advice to move forward building your property portfolio.

Happy investing

Felicity Heffernan

What is a credit score and can it stop you getting a loan?

Credit Score is a number calculated from the data on your credit report and is one factor used by lenders to determine your credit-worthiness for a mortgage, loan or credit card. The score compares you as a borrower, to the rest of the borrowers in Australia. Your credit score and credit report – are held by credit bureaus, such as Veda. Most lenders refer to Veda when checking your credit.

The credit score model involves a critical analysis of credit history across thousands of loan applications to determine what makes some borrowers more-risky propositions than others. Defaults, the number of credit enquiries on file, and the borrowers ‘credit shopping’ pattern are some of the pointers that can be used to derive a score. The score can be plotted on a chart or scale to provide a clear picture of whether the score indicates high or low risk. This means that defaulting on loan repayments could affect a borrower’s chances of securing a loan.

The national average credit score is around 760 which means that most Australians fall into the “very good” category when paying their loans.

The Veda credit score categories are below;

  • 833-1200 EXCELLENT You’re in the top 20% of Veda’s credit-active population, suggesting it’s HIGHLY UNLIKELY that an adverse event could harm your credit report in the next 12 months. Your odds of keeping a clean file are 5 times better than Veda’s average population.
  • 726-832 VERY GOOD Your Veda Score suggests it’s UNLIKELY that you will incur an adverse event in the next 12 months that could harm your credit report. Your odds of keeping a clean credit report are 2 times better than Veda’s average credit-active population.
  • 622-725 GOOD Your Veda Score suggests it’s LESS LIKELY you will incur an adverse event that could harm your credit report in the next 12 months. Your odds of keeping a clean credit report over this period are better than Veda’s average credit-active population.
  • 510-621 AVERAGE If your Veda Score is between 510 to 621, your credit score range is Average. Your Veda Score would suggest it’s LIKELY that you will incur an adverse event such as a default, bankruptcy or court judgment in the next 12 months.
  • 0-509 BELOW AVERAGE If your credit score is Below Average, you’re in the bottom 20% of Veda’s credit-active population, suggesting it’s MORE LIKELY that you will incur an adverse event such as a default, bankruptcy or court judgment in the next 12 months.

Credit scoring isn’t the only tool lenders use when assessing loan applications. They may also use their own credit application score and other criteria to decide if an applicant is suitable for a loan. That been said as technology advances some companies particularly those offering personal loans are approving loans based on a customer’s credit score and 3-month bank statement.

One of the BIGGEST MISTAKES you can make is shopping around for credit. Every time you apply for credit and a credit provider obtains a copy of your report, an enquiry is added to your credit report. This includes any loan; mortgage or utilities applications you may make. Credit providers may take a negative view of a relatively high number of enquiries made in a short space of time, which may in turn affect your ability to obtain credit.

Use a mortgage broker to do the leg work for you. A mortgage broker has the ability to make enquiries with lenders without enquiries noted your credit report and affecting your credit score.

If you want to get a copy of your credit score, Google “credit score Australia” – a good number of companies offer it for free if you sign up on their mailing list.

I would also encourage everyone to get a free copy of their credit report to see what has been recorded on you – http://www.mycreditfile.com.au/products-services/my-credit-file

Happy investing!

How to negotiate substantial discounts when purchasing a property

Most people think negotiating is about a win / lose situation. In other words, they are focused on their outcome not on what the other party wants. The reality is that you really can’t get what you want until that other person gets what they want. In order for that to happen the other person has to actually tell you exactly what they want or you have to ask lots of questions and be prepared to listen to understand what they want. The latter is usually the best way of extracting information to understand what the other person wants.

The first step when negotiating a property deal is to know exactly what you want and what you are prepared to pay. Knowing the type of house, you are looking for and what you plan to do with the property once it comes into your possession. This will require market research. The second step is to know what the other person wants, sometimes that can be a little tricky especially if the other person does not really know what they want.

The properties that often have the most potential are the ones that smell really bad. Many of my property investor friends would refer to this as the “smell of money” because it was very easy to fix a house that smells bad. A smelly house turns most people off, which makes selling difficult. This type of property usually requires the carpet to be ripped up and replaced or the floor boards sanded and polished rather than replacing the carpet. The polyurethane can be the best way to get rid of the “cat pee” smell entirely. Other simple quick fixes such as sugar soaping walls and tidying up the outside appearance add tremendous value. These houses once cleaned up present beautifully, they have increased rent potential and increased ability to sell for profit.

Properties don’t have to smell bad in order to get a good discount on the price. Often properties that are presented in an untidy fashion can be identified as properties that are likely to be highly negotiable. The number one reason people sell and don’t care how the property is presented, is because they are over the property. Situations like; the tenant living in the property has been nothing but a pain, they are so tired being a landlord and are over dealing with the tenant and just want the property sold. The other common reason is that the owners have separated, it has been a nasty separation and they are desperate to move on. Sometimes the reason is the owners have moved elsewhere and have started a new life, maintaining the upkeep on the old property is a low priority.

For many people selling a property for the best price is not the top priority, moving on, is their top priority. This goes back to the paradox of negotiation, in order to get what you want you have to make sure that the other people can get what they want. As a property investor you are always looking for a discount on a property and in many cases people will give you a discount because they need to get rid of the property. Knowing what you want and being highly organised with finance puts you in the box seat for a successful negotiation.

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