Interest Rates - fixed vs variable
 Negative gearing can be a great way to get your foot in the door to the investment property market, but it pays to do your homework first so you’re not left with a cracker loan you can’t afford to pay.
Negative gearing is defined as borrowing to invest in property, where any income you receive from that property is less than your borrowing costs. These losses can then be deducted from your taxable income and hence reduce your tax bill.
Take this example. David had saved a $50,000 deposit which he used to purchase a $500,000 investment property. He borrowed $450,000 from the bank and covered all of the additional purchasing costs from his own pocket. He plans to keep the home for around 10 years, then sell it and repay the loan in full. The home is currently tenanted at $1400 per month but David’s mortgage repayments are $3495 per month, leaving a shortfall of $2095 per month, which accumulates as $25,140 per year. At the end of each financial year, David can have tax deducted against this financial loss.
A popular wealth creation strategy, negative gearing lets everyday consumers invest in the property market through access to additional funds. “The intention of all gearing for investment purposes is to access a larger pool of money, namely the investor’s own stake together with outside loan funds - than if only a smaller pool - the investor’s own stake by itself - had been used,” says Nick Renton, author of Understanding Investment Property and Negative Gearing. “This produces a much higher net return for the investor and a larger benefit from inflation.”
Like any investment, there are uncontrollable factors that could impact on your plans, especially in suburbs that have experienced negative growth in the last 12 months. It’s also important to consider the possible impact of any interest rate rises or having an investment property untenanted for an extended period of time.
While negative gearing can be an effective way to make financial gains, Nick Renton cautions investors to thoroughly consider the pros and cons first. “Apart from the possibility of making a loss instead of a profit, a borrower can also face the situation that he or she will not have the necessary cash resources to repay the loan on its due date, or at all, and that the lender will be unwilling in the circumstances to roll over the loan.”
Common negative gearing mistakes:
• To aim at minimising income tax instead of maximising returns
• Think that an investment that does not stand up on its own merits can be made attractive by negative gearing
• Not to realise that while a tax loss from negative gearing can be attractive in isolation, it is also automatically accompanied by an even larger actual loss
• To forget that while gearing can increase profits, it can also increase losses
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