What to do - Bought first home, settlement soon, only want it for 2 years then IP it

Hi all,

I am a 24 y.o, and have just purchased my first home with my wife. Settlement is due in about 2 weeks time.

We are borrowing approx. 295k from the bank, as we were fortunate enough to give a 20% deposit for the loan and cover all fees (with slight help of FHOG).

My question is regarding the structure of the loan versus our potential plan for the property..

The plan:
We only want to live in the property for around 2 years (max).. after that, we plan purchase our second property to live in, and hold on to this one and rent it out.

Our combined income is currently around 110-115k (before tax).

• Should we focus on reducing our mortgage for this property as quick as possible? (so that when we do rent it out, the difference we have to make up for [mortgage repayment versus rental income] is minimised)
  or
• Should we pay back the minimum for Principal and Interest and then build up savings for a second property in an offset account?
  or
  other suggestions?

By the way, we purchased the property privately (it didnt even hit the market). We got it for a low price, which seems to be about ~50-60k less then what it would sell for on the market now.

I'm good with numbers, but not great with the tax benefits side of things..

According to my budget calcs.. we COULD put all our money into the mortgage for the first two years.. and then by that stage, if we were to rent it out, the rental income would cover the mortgage repayments.

Thanks in advance to all those that provide a response.

T

 

T,
Well done on your purchase.
If your intention is to live in it for 2 years then rent it out as an investment property and you want to purchase another property to live in, I would think about using an interest only loan with a 100% offset for the first property.
Build your offset as fast as you can as that will be the funds used to help settle your next home and to minimise the borrowings you will have for the next property.
Depending on the numbers, I would even consider borrowing 85 to 90% for the first property to better preserve your own funds. Do your numbers to decide whose name the first property should be purchased in and what your long term goals are.
If you need further explanation for the reasoning, let me know
Greg

 

Hi Greg,

Thanks for the prompt reply.

I don't completely understand the reasoning behind it all.

We are not 100% set on a decision to sell in 2 years or rent it out in 2 years.. however, is it such a bad thing to start paying it off quickly either way?

Perhaps we really need to speak with a financial planner..


By the way, we went the 20% deposit option to avoid the LMI.. are you suggesting that after the settlement day, we would be able to redraw back to say 5-10%, and put that money into an offset account?
Is LMI only considered in the loan application process? Surely not something that can be tacked on later?



Tom

 

Tom,
Good luck with a FP - most are insurance salesmen at best and very few know much about real property at all, they don't make money out of it and in most cases they cannot give advice because their platform provider/insurance does not cover it (no offence to the few good FP's out there).

You would be better seeking a good tax accountant who is a property investor themselves.

Paying down debt is the ultimate strategy but it is about getting the timing right and that depends on your own circumstances and your own goals. I have seen too many clients pay down their own home, then circumstances change, they want to buy another home or upgrade but are in a position to keep the first property as an IP, but the decision to pay down debt in the first place now bites them big time. There are many examples of this happening on this Forum. It can cost $'000's of dollars.

Paying any surplus funds into an offset account from the start will achieve reduced interest costs on your initial home loan.

I do not suggest you redraw after settlement to put into an offset account, it will serve no purpose as the interest on that portion of the additional loan will not then be able to be claimable as a deduction if you did convert this into an IP. You need to do it before settlement and more than likely if settlement is in 2 weeks, you do not have time to rearrange this. It was more a note for others looking down the same path.

If your intention was to keep this property as your home long term, then by all means pay down the mortgage. If you then wanted to purchase an IP later, you then refinance your home to set up a LOC or another IO loan or both and you can legitimately use 105% borrowed funds to purchase the IP. As I said before, the right strategy will depend on your own goals.
Greg

 

Just to expand on what GregR has said with some example figures:

Scenerio 1

You borrow $295k (80% LVR) of the house price. Loan is setup as principal and interest repayments and has a redraw feature. All extra savings are paid into the loan. Say over the two years you saved an additional $50k (so the loan now has a balance of $245k).

In two years time you convert the house to an IP and buy a new PPOR - redrawing from the original loan for the deposit.

You now have a loan with a balance of $295k - however only $245k of it was used for purchasing the house that is now an IP. So only the interest on this part would be tax deductable.

Scenerio 2

You borrow $295k (80% LVR) of the house price. Loan is setup as interest only with a 100% offset account. All extra savings are placed in the offset account. Say over the two years you saved an additional $50k.

In two years time you convert the house to an IP and buy a new PPOR. The money you have saved in the offset account ($50k) can be used for the deposit for the new PPOR and the full interest on the original loan (295k) will be tax deductable (as this loan was used to purchase the house which is now the IP).

You are better off in this scenario by $50k x interest rate x your margin tax rate per year.

Scenario 3

You borrow $331k (90% LVR) of the house price. LMI will most likely be charged but you capitalise it onto the loan. Loan is setup as interest only with a 100% offset account. The extra $36k (approx) you have in cash is placed in the offset account, as well as all extra savings. Say over the two years you saved an additional $50k.

In two years time you convert the house to an IP and buy a new PPOR. The money you have saved in the offset account (now $86k) can be used for the deposit for the new PPOR and the full interest on the original loan (331k + lmi) will be tax deductable (as this loan was used to purchase the house which is now the IP).

Whether or not this is better than scenario two would depend on some detailed calculations and how long you are intending to take to pay off the debts.


Regards,

Jason

 

Well explained Jason

Interest on $86,000 would be about $6020 pa. This would mean if you followed this strategy you could have up to $6020 pa in extra interest which you could claim. Possibly $2000 pa cash in your pocket.

Now think of the compounding effect of paying $2000 pa (or $166 pm) off your home loan over x years.

 

Wow, great responses. Thanks all!

Definitely given me a lot to think about.

Settlement is due on Nov 18, and the bank has approved our loan for 296k.
So I think we are locked in for handing over the full 20% deposit..

I am still confused as to why not make principal+interest payments? It seems logical to me, to pay more than the minimum (which we can well afford to do), therefore reducing the interest owing.

Surely this is more of a saving than 6k or even 8k per year..?

 

It may take a while for it to sink in, but you will be saving the same interest with IO and the offset (unless you are tempted to spend the extra money you save). The different is the tax treatment down the track.

 

Ok so lets say its 296k.. at around 6.66% IR.
That about $19,713 per year in interest.
So $39427 at 2 years..

Of this amount, how much is tax deductible? - If we went for Scenario 2 above

Extra info:
* In a 1 year period, based on my current salary, I would get taxed around 14.5-15k (as I am continuing to pay HECS debt).
* My wife would get taxed about 9.5k

 

Once you move out of the home and rent it all $19,713 would be deductible each year.

 

Thanks Terryw

As GregR mentioned in his second post - 'decide whose name the property should be purchased in';
am I correct in saying this would be the higher income earner?

Also - Lets say its fully paid off, and could be rented out for $350 a week..
= $18.2k per year.

Is this a goal at all? or are you suggesting the tax benefit is better?

 

TC,

Many issues to consider which name to buy under. Tax, family law, estate planning, insolvency etc.

Purely from a tax point of view putting it in the name of the higher income earner may result in higher deductions initially. But the goal is to make money so if you sell for a profit or keep it and the rents increase this could result in more tax being payable.

Paying off an investment is generally a good thing. But you wouldn't want to pay this off before paying off a new home loan (PPOR). Imagine if you paid this off and were receiving $18,000 pa (and it was in the name of the high income earner). You would be paying a lot of this in tax. Imagine at the same time you still had $300,000 owing on your new PPOR loan. $18,000 pa approx in interest which you could not claim!!!!

 

Excellent scenarios!

I have developed a home loan structure calculator based on the following scenario:

You buy 1st property now and want to buy the 2nd after a few years.

How you should structure your loan? Should you choose P/I or I/O for them? What if you want to use the 1st one as an rental property after several years.

The calcualtor can show you 30 years projection.

Anyone wants a trial, please email me shiyuquan at gamil.com

Cheers,

Pat

 

Thanks again for the responses everyone..

Our home loan has settled last Friday and we officially own it now!


We used a lot of our savings to put forward a 20% deposit.

The plan from here is still the same:
- Definitely move out of it in 2-3 years time and either
a) Sell it
b) Keep it and rent it out

- In the mean time, we hope to renovate it a little bit over the coming months/year..
- Ideally, we would also like to do some short travel stints in the next 2-3 years..

I need to make a concrete decision now with what I am doing with the loan..

It is currently set up for Principal and Interest repayments..
However, I am thinking that we should do the Interest Only and 100% offset account option.

Can anyone confirm in general that this would be the wiser decision to make?

 

IO with an offset would generally work out better. This is because it will save you the same interest and keep the loan higher which will result in a better tax position if you were to move and rent it.

The only exception is if you will be tempted to spend the extra money in the offset account. Some people are tempted by the feeling that you have large amounts of cash available.

 

Ok so what about if I just pour all my extra money into my Home Loan account - which has a free redraw facility..

Say I live in this house for the next 3 years and in this time I have made extra repayments, and after 3 years I have 60 grand equity in my house.. I can redraw everything I have put into the loan, use my equity to buy a new place, and then refinance this current place as an investment property..

 

Please see above.

If you did pay $60,000 off your home loan then used redraw, the interest on this $60,000 would not be deductible if the money was used for the purchase of a main residence.

This would mean approx $60,000 x 7% = $4,200 pa less in tax deductions.

 

Your New Home

Just want to say Congrats on your new home! I remember when I bought my first home in my early 20s.

 

Thanks TonyFawaz - It is quite exciting. I don't want to get too caught up in these financials, still want to have fun and be young! But I do want to get a good plan sorted from the start and stick to it!


OK
Decided to bite the bullet and just do it. Gone for Interest Only with 100% offset account.

As we have picked up the property at a price that is a fair bit below market value, we hope to get it re-evaluated in 6 months and then refinance to have money to spend on renovations, etc.
Or.. Use the money that we have built up in the offset account.

Thanks for all your advice.