An all important disclaimer…
Don’t make big decisions based on one or two posts that you read.
When considering to refinance a property, be sure to consult with someone who understands property investments, taxation and your specific goals and plan.
I’m going to share a little about my own property investment thoughts. This post is not to be taken as an exact plan, or as the only way to do something. The idea is simply to make you see things from another perspective. Or to get a new idea.
There is also a lot more to this concept than what can be explained in a post and it’s a good idea to read books on the matter and even attend property investment courses to learn all you can.
So two things to note:
Firstly, my properties are owned in a trust. If you’re not sure what a Trust is or why one would do this, have a look at these two posts:
Secondly, this post relates to investment properties that are being rented out. One may refinance your main house that you live in, but that will require some different calculations and considerations.
Why I like to use a Trust
At a high-level, I like to use a Trust as I can build wealth in the Trust which will then remain in tact for future generations. So yes, the trust is in a higher tax bracket, you do pay accountants fees and have extra admin. But when I die, no bank accounts will be frozen, no estate duties will be payable for assets in the trust. In fact, nothing about the trust will change besides that a new Trustee will need to be appointed.
So properties, loans, rentals, investments, etc all just continue as per normal for my family.
I like that.
However, Trusts don’t make sense to everyone and they can add extra complication.
Do your own research on this.
When it might make sense to refinance a property
Even though I really go out of my way to pay off any debt in my personal name and to live a debt-free life, debt can be useful and can be a tool with which to generate wealth. See how to use Other People’s Money to make money.
It can be risky though and is not necessarily a good idea for everyone, but let’s look at some calculations.
- You bought a property a few years ago for R600,000
- Outstanding debt R350,000
- Current value R800,000
- Monthly instalment is R5,800
- Current rental R6,000
- Annual rental increase of 8%
If you had to refinance your home and are able to get 100% loan to the value of your home, the figures will look like this (plus minus).
- New loan is R800,000
- New instalment R7,700
- Current rental still R6,000
- “Cash out” R450,000
So in this example you will taking out additional debt, the instalment will be higher and you are tied down to longer debt.
So why would you refinance a property?
Firstly, remember that you pay tax on any income you make off your property. And as the rental income increases and the outstanding debt decreases, the taxable portion increases.
In fact, once the property is fully paid off, the full rental income is taxable.
So this may seem like a weird way of thinking, but the R450k that you receive as a “cash out” is actually the next 5 years worth of rental income that you’re receiving now upfront. And because this is a loan, there is no tax payable.
So think of the refinancing of receiving upfront rental for a few years without the tax burden.
What about the increased instalment amount?
In this example, the instalment is R1,900 higher. And if we do a simple calculation increasing the rent by 8% each year, we can work out that the rental will cover the bond repayments in the 5th year.
The difference between the rental income and instalments before it breaks even is around R45k.
So if you take R50k from the cash out amount and set it aside, you will have no impact on your cash flow.
Thus, for the next 5 years the property will pay for itself and yet you have taken R400k as a cash payout.
What to do with the cash out?
This is a very personal decision and depends a lot on your own circumstances, your goals and your overall investments.
Previously when I have refinanced a home I have used the full cash out amount less the amount set aside for increased instalments and then used that towards a new property.
But, I have also sometimes taken a portion of the cash out to use for my own personal enjoyment.
A good principle to work towards is to keep a third specifically allocated to the property (maintenance, instalments, emergencies, etc). Keep a third for your investment strategy and take a third for yourself.
However, find something that makes sense to you.
Don’t just blow the money, that would be silly! LOL
Refinancing your property (or gearing it) can be a very powerful tool to build wealth. It is tax efficient, and it also uses the concept of Other Peoples Money (post to come soon).
The risks involved when you refinance a property are:
- The prime interest rate increases tremendously and messes up your cash flow.
- You lose your tenant and the property is vacant for 2 – 3 months.
- You don’t have an emergency fund, and well, emergencies happen
If you sail too closely to the wind in terms of month to month cash flow, or cash available in your emergency fund, things can go very wrong.
But if you simply keep a large portion of your cash out money allocated to the property, you do your calculations pessimistically and assume the worse, then you’ll be fine.
Learn how to do this and build wealth.
Check out my course on understanding how loan payments are calculated and how to draw up your own spreadsheet to see the effects of additional payments on your home loan.