This will involve a very important concept of wealth creation: Control vs Ownership. By not paying off the mortgage you are not after ownership. But even without the ownership, you will realize that you have full control as if you own it. So, isn’t it better: still have the same power, but you pay less and even have more profit for your investing.

Before we go, I have to warn you that this topic is quite advanced. To benefit you have to have investor mindset and you need to be comfortable having debt. But to tell you the truth, if you’re not comfortable with debt and don’t have investing mindset, then you will have more hurdle to overcome in your journey achieving your financial freedom.

To Own or To Control

If you own “something”, what can you do with it ? Well, practically you can do almost anything(with certain restriction as allowed by law, of course). You may use it, modify it, you may sell it, you may gift it to someone else, etc. And of course, your name will be on the title of ownership.

For example: you own a house. Then you can stay in it, extend it, paint it, sell it, rent it out, renovate it, etc. And your name will be registered as the owner. If you buy the house outright then you will see the “Title of Ownership” straightaway, but most of us would see that title after we pay off the loan, say in 25 years.

But how about if you still have all the power as if you own it (only with a bit restriction) and the only real different is that your name is not in the “Title of Ownership” or that you will never see that ownership certificate ? This is what we refer as “controlling” instead of owning.

For example: let’s go back to the house on above example. You can still stay in it, paint it, extend it, sell it, rent it out, renovate it, etc (although you cannot just give it to somebody else). The only real different is just you never see the “Title of Ownership” in your hand as it will be held by the lender. Will you choose just control the house if you pay less money and give you better profit as investor ? Of course!

How do you control a property as such ? Rent it ? Although rent a property can give you certain control in using it as place of residence, it doesn’t give you the power as if you own it. The answer is by taking “Interest Only” loan.

“Principal & Interest” Loan vs. “Interest Only” Loan

Normally, when you apply a home loan for your own home, you will get what so called “Principal and Interest” loan. Say you take 25 years term, then after 25 years, assuming you don’t miss any single repayment, you will pay off your debt and you fully “own” your home.

When you take “Interest Only” loan, your intention is just to control the property, there is no intention of paying it off. In this example, after 25 year your debt is still not a cent less.

Now let see why – for smart investor – controlling  is a much better alternative compare to ownership. (by taking “interest only” loan – even for your own home)

The real key is the cash flow saved by “interest only” loan. In “Principal and Interest” loan, every repayment consists of 2 component: interest component and principal component. In “Interest Only” loan, you don’t pay the principal component. Hence you make cheaper repayment month after month. The question is: What a smart investor can do with this ‘spare’ cash flow ?

For example: You buy $440,000 house. You pay 10% deposit of $40,000 and take a home loan of $400,000 for 25 years term with 7.75% interest rate. Your monthly repayment if you take ‘normal’ Principal and Interest loan will be $3021 per month. On the other hand, Interest Only loan only ask you to pay $2583 per month. A cash flow saving of $438 per month (or around 14% cheaper).

(You can use this online home loan calculator to check the your own number)

Let say we stick to the real estate sector. What can one do with $438 per month / $5252 per year? Can’t it be invested on a say small $225,000 bachelor unit in the outskirt of the city which can attract rent of $225 per week?

Let’s do some rough calculation:

• Let us take 100% LVR (Loan to Value Ratio) loan. Say we got 8.0% p.a interest only loan (usually 100% LVR loan will have higher interest rate, so we use higher rate than 7.75%), the interest payable yearly is $18,000 per year.
• Say we need around $2000 per year for council, strata/owner corporation and landlord insurance.
• So, total cash flow required to maintain this second property is around $20,000 per year.
• $225 per week rental income converts to $11,250 per year (assuming 2 weeks / 4% vacancy rate, hence 1 year = 50 weeks only )
• If you’re on 40% income tax’s bracket, the deduction you received at tax return will be 40% x ($20,000-$11,250) = $3,500.
• Total cash flow available: $11,250 (rental income) + $3,500 (deduction) + $5,252 (spare cash flow) = $20,002 per year. Just enough to cover the expense.

Now let’s do side by side comparison what happen after 25 years (when you supposed to pay off the mortgage):

So, by taking ‘interest only’ loan and invest the ‘spare’ money if it were ‘principal & interest’ loan, at the end of loan (after 25 years) you end up $340,671 richer (average additional $13,627 per year) or better off by whopping 18%.

Important Parameters:

The important factors that make the numbers works, in order of importance:

1. Negative Gearing scheme. Your tax system need to give a tax deduction if an investment makes a loss (In this case, on second property costs you $20.000 per year while only making $11,250 per year rental income). If Negative Gearing is not available, you need to ‘chip in’ the additional money required to serve the 2nd loan (In this case: $3500 per year or $291 per month)
2. Property Growth Rate. The higher the growth the more benefit you can reap. In Australia, for the last 30-40 years, the property doubled in value within 10 to 15 years or around 10% per year. If I were to say “This $300,000 property will worth $600,000 in 10 years”, people tend to question that as if they don’t believe it. But if I say “This $300,000 property worthed $150,000 10 years ago”, people tend to believe it and comment “Gee, I should buy 2 before”. But the figure exactly the same: average 10% growth per year. That’s what we call the hindsight.Trying to be more conservative, we only use 6% growth in the calculation. Of course, in short term, even property can get negative growth (subprime mortgage crisis, ring a bell?). But over longer time peiod (in this case 25 years), as long as demand (population growth) more than supply (property availability) the price of the property will always always go up.
3. Interest Rate. The lower the interest rate, you will save more (percentage wise) between Interest Only loan and Principal+Interest loan.

• Loan of $300,000 for 25 year with 8% interest p.a: P&I=$2,315p.m. I(interest only)=$2,000p.m. Save 13.6%
• Loan of $300,000 for 25 year with 6% interest p.a: P&I=$1,933p.m. I=$1,500p.m. Save 22.4%
• Loan of $500,000 for 25 year with 8% interest p.a: P&I=$3.859p.m. I=$3,333p.m. Save 13.6%
• Loan of $500,000 for 25 year with 6% interest p.a: P&I=$3,222p.m. I=$2,500p.m. Save 22.4%

Things to remember:

• No deduction for interest on your place of residence (the 1st property above)
• People usually pay off their loan faster by paying extra on their Principal+Interest loan. The comparison effect can be achieved as well on ‘Interest Only’ loan by using “offset account”. You just put the extra repayment in the offset account so the amount of interest will be reduced accordingly (the amount of extra money will reduce the total debt)
• You need to calculate your own number. For every different circumstances, there might be different kind of 2nd property that need to be purchased. (In the near future, I will put this calculation tools on this website)
• If you can afford extra money, you can consider buying bigger property for the second one. This will bring more benefit at the end
• There is additional risk that need to be considered: for the 2 properties in the example you need to carry total $625.000 debt. And the debt will never decrease (as you only pay interest only, not the principal). Hence, in the event of unwanted situation, you need to make sure life insurance/trauma insurance or income protection insurance can cover the expenses and you o your family can still serve the loan.

Conclusion

Explained above with quite detail example of why by not paying off your mortgage you will end up with more profitable situation.

The key is to save some money by using ‘interest only” loan instead of “principal + interest” loan. Then use the money to invest in another property (of course you can do it in the stockmarket as well). The significant difference is that you will not gain the ownership of the property although still gain full control. Also you need to be comfortable having debt and have the necessary cash flow to serve the loan.

— Denis Kristanda

Without being too technical, we will discuss and calculate all the important numbers for both method. We also provide you with free tools to calculate the number based on your own situation. But the most important thing which method is the best? It will be revealed in an instant by the numbers. Let’s get started.

Negative Gearing

Negative Gearing simply means the income from the rent cannot cover all the cost (mortgage, repair, maintenance, strata/land tax, council rate, etc). Hence, the owner of the property need to come up with the money every month to hold the property.

For example:

We buy property for $330,000. Put 10% deposit ($30,000), and borrow the rest from the bank with 8% interest rate on interest only loan. The property is then rented for $350 per week. All other costs (strata/land tax, council rate, repair) , let say, is $2,000 per year, therefore:

• Loan: $300,000 at 8% interest the annual cost will be: $24,000 per year
• Rental income: $350 x 52 weeks = $18,200 per year
• Total cost: $24,000 (loan’s interest) + $2,000 (other cost) = $26,000
• Since total cost ($26,000) is larger than rental income ($18,200) then we have a negative gearing investment here.
• We need to ‘cover’ or ‘negatively geared’ the property at $7,800 per year or $150 out of pocket every week.

Negative gearing is very common, so we probably are pretty familiar with this scenario.

Positive Gearing

Positive Gearing simply means the income from the rent is larger than all the cost (mortgage, repair, maintenance, strata/land tax, council rate, etc).

For example: let’s use exactly the same property above, so we really do fair comparison. To make that property a positive gearing investment, the rental income need to be higher than the total cost, hence:

• Minimum rent per week = $26,000 / 52 weeks = $500 / week.
• So, if we rent the property for more than $500 per week, then we have a positive gearing investment because the rental income exceeding the total cost.

If the rental income only cover just about the cost, people also refer this as “neutral gearing” investment. Only if we have quite significant surplus, say $100 a week more – or $5200 per year surplus (means we need to rent it for $600 per week) – then we are enjoying a positive gearing investment the most.

By now probably we are puzzled already. How the heck we can rent $330,000 property for $600 per week ? There 2 simple answers for that:

1. In the low growth area: small city / rural / remote area.
   You might know that the price of a property is very cheap in area outside the city. Say your $330.000 property is probably priced only $110,000 there. But will the rent also 1/3 of the city ? The answer is most probably “no”.

   The rent is not really proportional with the price. Say in this case, that $110,000 2 bedrooms unit in this remote area probably rent for $180-$200 per week. Also, the rate will be cheaper. So if we do the same calculation like above, we will find that the property is an positive gearing investment.

   In reality, probably there is not many $330,000 property in small city/rural/remote which rented for $600. For this comparison, you may relate this situation with having 3 properties with price of $110,000 each and each of the property is rented at $200 per week. (A bit more realistic?)

2. Over Period of Time:
   After a period of time, say 5 – 10 years, the value of our property is not the only one growing, the rental income also grows. Let see on this example: we start with negative gearing condition and rent the property for $350 per week. After 2-3 years, for sure we will increase the rent as the market goes. Yes, the cost probably go up as well, but after several increase, we will reach a point where the rental income will cover all the cost.

The Drawbacks

Don’t be mistaken, Positive Gearing investment is our ultimate dream. Once our property is no longer a negative gearing, we received money every week to the bank while the value of the property is still growing. The bigger thing is, that we can tell the bank that we are ready for the next property since this positive gearing property is practically self funded. The bank will happily lend you money to buy another property.

But having said that, before you swarm all those properties outside the big city, there are 2 major important factors that become the drawbacks:

• The growth in small city/rural/remote area usually significantly less than the big city
• Tax benefit for negative gearing

Why this is important? When we are talking about investing, we need always talk about the Return of Investment (ROI). Since the price of the property (in dollar value) is very big compare to the rent, then small difference in growth of the property will significantly change our ROI. Let see.

In Australia, we can expect the property will be doubled in value in average of 10 – 15 years or 7% – 10% per year. But let us be more conservative, say in the big city where our property belong, the growth is only 5%-7%, but in the small city/remote/rural area the growth is only 1-2% (most likely less). Then our hypothetical $300,000 property will give us:

In our example above, assuming the rental is not changed for 3 years::

• Negative gearing, in the city with 5% growth , out of pocket= 3 years x -$7800 per year = -$23,400
• Positive gearing, in small city rural/remote are are with 2% growth, income = 3 years x +$5200 = $15,600

Here is when the tax benefit factor kicks in. On positive gearing scenario, that $15,600 is income, hence subject to tax. On the other hand, the negative gearing benefit makes the out of pocket money that we pay become a tax deduction. So in this case, depends on your tax rate, the tax payable and deduction are as follows:

Therefore,

The real ROI

Yes, it seems that the negative gearing produce almost twice the positive gearing. But, please do not jump into any conclusion yet.

Now that we have the dollar value of our ROI , then we need to see the real percentage of our investment. On positive gearing scheme, our only capital is the 10% deposit ($30,000). The additional cost and the interest are pretty much self funded (fully covered by the rental income). But on negative gearing scheme, we need to come up $7800 every single year to cover the cost and interest. So, here is the final figure:

Analysis

What we can derive from these numbers ?

1. Both positive and negative gearing produce similar result (around 100% ROI after 3 year)
2. If we have lower tax bracket, positive gearing investment is better
3. If we have higher income bracket, negative gearing investment is better
4. Negative gearing requires more capital

The Side by Side Comparison

Conclusion

Although we have proven that both scheme produce similar result, there is one other factor that makes positive gearing investment not really popular: it is significantly harder to find such property (need to find further and further from crowd) and also it’s harder to find and maintain the tenant (vacancy rate is higher). Also the more remote the site is, only few lender will give the money easily. Even if they do, usually the LVR (Loan to Value Ratio) will be lower than the city (you need more deposit money).

Having said that, if all risk has been taken into consideration and taken care of, if you can find a positive gearing property, by all means go ahead! You just found a gem.

The best alternative
If positive gearing investment is too difficult, then the best alternative for investing in property to get the maximum result:

1. Get property in high growth area, normally in the big city.
   It means, we need to use the negative gearing scenario at first.
2. Make that property become positive gearing as soon as possible.
   (See other articles about this)

Using this method, you will enjoy the maximum benefit of negative gearing, while at the same time reaping the value of high growth area.

Free Tools: All the simulation and calculation above can be customized based on your situation and your number at Property Gearing Simulator. So you can make better decision whether to invest in negative gearing or positive gearing.

Happy Property Investing !

Disclaimer:

• The article and tools presented are for general informational purposes only . It’s exclusively your decision whether or not to apply it to your investment. Before making any decision about the information provided, you must consider the appropriateness of the information in regard to your objectives, financial situation and needs. If in doubt, you should consult your adviser or investment professional.
• You might be eligible or liable for other deduction or cost. Please refer law / rules / regulation that applied to your situation and jurisdiction.

— Denis Kristanda