By Helen Collier-Kogtevs
One of the most common mistakes that property investors make is to take on too much bad debt – that’s debt that isn’t income producing, or attracts interest that’s not tax deductible. Typically, bad debt includes credit card and personal loan debts.
When it comes time to apply for a new loan to buy an investment property, the amount of your income that’s needed to service your bad debt is deducted from your total income, which is then used to calculate the amount that you can borrow. The end effect is that your borrowing capacity is diminished by your bad debt – just how much, however, will depend on how much bad debt you’ve actually got.
Many people don’t realise how much of an impact bad debt can have on their borrowing power. For example, a $30,000 credit card limit could reduce your borrowing power by $109,500.
The message is simple: how do you expect the banks to lend you money to build a property portfolio if all you have is a stack of credit card bills, personal loan statements and a massive mortgage over your dream home?
I struggle to understand how people can borrow all that they can to spend on their own home, leaving them nothing for any future investments. They max their bad debt, make minimum repayments each month and then wonder why the banks won’t lend them any more money to buy an investment property.
I understand that we’ve been raised in a society where borrowing money is an acceptable practice – especially bad debt – and it seems that this attitude is being passed on from generation to generation. This attitude has given rise to the many bad debt borrowing schemes that allow people to borrow interest–free, repayment-free for periods of up to four years
Bad debt is actually what keeps you in the day job longer; if you’ve visualised retiring at an early age, laying back on a deck chair, enjoying life and playing golf, then keep bad debt out of your investing equation.
Rob and Jane are married with two children and live in the outer suburbs of Brisbane. Rob earns $90,000 pa while Jane works part-time, earning $30,000.
They have a mortgage of $450,000 on their family home. Their credit card limits total $25,000 and they’ve purchased a new 4WD worth $50,000 with monthly lease payments of $1,037.
Total net income: $91,500 pa
Total debts: $64,476 pa
Available cash: $26,625 pa or $512 per week
They want to buy an investment property and, to their disappointment, find that the banks won’t lend them any money. With over $500,000 of bad debt, the risk is a high one for the banks to take on.
This couple has worked hard for their money, and believes they should be able to enjoy the fruits of their labour. They own a 109cm wide screen plasma TV, and have a swimming pool for the kids and their friends to play in.
Financially speaking, this dream isn’t so rosy. If Rob and Jane both lost their jobs, they wouldn’t be able to pay the interest on their loans and would have to default on them. If the situation continues too long, it could potentially lead them down the path of bankruptcy. The interest on the credit cards, car loan and an owner-occupied mortgage on a $450,000 house all add up.
The figures show that Rob and Jane have, after tax, a total net income of $91,500, while their current mortgage and car payments total $64,476 per year. This leaves them $26,625 per year, or $512 per week, to feed, clothe, entertain, put fuel in the car, cover credit card payments, attend sporting activities, go on holidays, and educate the family. They’d be considered to be living on the cusp, and vulnerable to interest rate increases.
With the above financial position, Rob and Jane would only be able to borrow approximately $3,000 towards any wealth creation.
If we reduce the credit card limits to $5,000 and instead of a brand new 4WD, Rob and Jane lease a secondhand 4WD valued at $20,000, then their borrowing power will now be increased to $133,000. To add to this, let’s change the mortgage payments from principle & interest to interest-only to increase cash flow. This simple change would increase their borrowing power to $159,000.
Then by adding an investment property earning a weekly rent of $250, their borrowing power would jump to $251,000, from the initial $3,000.
Imagine what the figures would be if Rob and Jane purchased a cheaper property with a smaller mortgage of $350,000, then their borrowing power would increase again to $329,000.
If Jane chose to work full-time instead of part-time, therefore increasing her income to $55,000 per year, their borrowing power would increase to a whopping $402,000.
If you use cash flow to reduce your debt, you’ll increase your borrowing power over time. The more personal bad debt you have, the more you’re trapped in having to earn an income to pay for it all. If you don’t have so many bad debts, it takes the pressure off you to earn more. Paying off bad debt is a simple strategy and something that should be taught to all Australians.
Helen Collier-Kogtevs is a director of Real Wealth Australia.
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