Finance expert Andrew Krauksts answers a reader’s question on the pros and cons of topping up a loan as opposed to taking a line of credit on a property.
Question: What's a better strategy to access equity: take out a line of credit or just top up our loan?
Answer: Lines of credit can be very useful; however, you need to be careful regarding an evergreen set-up in which no repayments are needed and the interest is added on to the loan. Years ago that was a sound strategy for increasing your tax deductible debt. This has been a very contentious subject with the ATO (and many court rulings), and my advice would be to stay away from such a strategy or ensure you seek expert advice from a tax expert that may require a private ruling to ensure you stay on the right side if you are seeking to capitalise the interest.
If you are looking to access equity from your home, it is never a good idea to top up the loan for investment purposes. The reason is that you are mixing together investment debt with personal debt. As an example, if you had an $80,000 home loan and you took out a $20,000 investment loan, your total single loan amount would be $100,000. This would equate to a ratio of 80% personal debt to 20% investment debt.
The challenge is that if you wanted to make accelerated repayments onto your home loan you would simultaneously be wiping out your investment debt. This would mean that every time you made a $1,000 principal repayment (not taking into account the interest portion charged) you would be – staying with the example of 80/20 – reducing your home loan by $800 but also wiping out $200 of the investment debt.
Why is this bad? Well, if you had a home loan for $100,000 and an investment loan of $100,000, it would make sense to discard the home loan first since it is not tax deductible. A great set-up would be to have both loans as interest only. Attach a 100% offset account against the home loan and drive all of your extra income into the offset account to eliminate interest repayments on your home loan. This also gives you the choice (should you ever move out of your home) to take all of the money out of the offset account and buy a new home, and instantly the entire interest is charged again against your old home, making it now tax deductible. It is never a clever idea to top up your home loan for investment purposes.
A better strategy
So how do you get around this without using your home as security against a new investment purchase? It’s simple: you apply for a separate loan against your home. Using the previous example, you would leave your $80,000 home loan in place and apply for a separate loan of $20,000 for investment purposes. This also makes accounting very simple because now you know which loan is for investment purposes and what to provide to your accountant at tax time.
If you are accessing equity from a property that you are already renting out, meaning that the existing loan is already tax deductible, it is still a good idea to use a split loan. From an accounting perspective it makes it easier to know which expenses belong to which property. This serves a number of purposes. From a business point of view, you can review your properties and work out what their holding costs are and their overall performance. Also, if you decide to sell any of your properties, you know which loans belong to which property and you can make a choice to either wipe out those loans or, from the sale, reduce one of the smaller loans to zero without paying it out, providing you with redraw capability should you wish to buy again (effectively turning that loan into a line of credit type function).
Using line of credit
Line of credit loans, in my view, are a good tool for two reasons. Firstly, they are great to have as a buffer. In cases of emergency repairs, etc., there is instant access to funds to assist you. Secondly, they provide instant access to cash, should there be a property-buying opportunity and you require funds quickly for a 10% deposit.
The negative aspect of a line of credit is that it can be more expensive than a normal investment loan. There can also be a negative impact on your borrowing power if you have a large line of credit. This is because a line of credit is like a gigantic credit card with a limit.
Let’s say you have a $200,000 line of credit with zero owing. Lenders, at the time of an application for new finance, will consider repayments as if the entire line of credit is drawn, therefore drastically diminishing your capacity to borrow. This could mean the difference between being approved or declined for finance.
A balanced approach is needed: a line of credit limit that takes into account your income and expenses position, leaving sufficient surplus funds from your monthly income (assuming your line of credit is fully drawn) to ensure a fresh loan application would be successful. A competent banker or broker can assist in calculating various scenarios to ensure your strategy works for you.
One way to get around a line of credit is to simply take out a normal interest-only investment loan. For example, instead of taking out an $80,000 line of credit, apply for a cheap, no-frills investment loan.
Once the money is available to you, simply transfer the $80,000 onto the loan, reducing the balance to zero. No interest is charged, and, if you require funds, simply use redraw for access. This way you have a low-cost loan with a line of credit functionality.
All these matters require forward thinking and planning. Take into account your overall goal and strategy. Devise a plan and then research the finance market, or seek expert advice to ensure that not only can you execute your plan today but you don’t get stuck at your next intended property purchase due to poor research, planning and execution.