How should I finance my property?

[donna]

Hi All,

A friend of mine has recently bought her first IP and settles in a couple of weeks. She has been getting advice on finance options and on Friday when we were out a couple of friends added their 2 cents worth.

It's not easy to make the right choice now as there are so many options. She gets approx $14K each month (before tax) but as a contractor probably pays tax once a year and she wants to save around $2K each month towards reducing the debt.

Most advice she's had so far is get a 2yr fixed rate mortgage. It's worth mentioning that in a couple of years she plans to have children so she won't have the $14K each month - her partner will be paying the mortgage.

She needs to borrow $300K - I'm not convinced the 2 year fixed rate is the most efficient option for her right now and suggested she doesn't jump in on a fixed rate for all the borrowing as she could get a lot of leverage off having $14K+ in her account each month on a revolving LOC loan.

The difference between fixed and variable/floating is 1 - 1.5% and on a $300K mortgage around $28 per week. I wonder why we are so focussed with fixed rate when I have been told many times that you pay less interest with variable rate mortgages?

My thought was that if over the next two years she saves more than $2K per month and she has the saved $$ accumulating in her LOC - coupled with her $14K each month (which would reduce during the month but for a good part of the month there may be around $6 - 8K sitting in the account. Then she'd pay less interest in the LOC than if she had a fixed rate mortgage - am I right with this line of thought?

Isn't she better off reducing debt than putting the $$ saved in a high interest savings account as the borrowed rate is higher than the investment rate?

Umm so much to consider So if you split the borrowing what would be the best split? $100K on fixed rate and $200K on variable?

Cheers,

Donna

[cube]

If she is paying tax yearly, and has the discipline to have a LOC account, then I'd say, yes, do that.

Fixed interest gives certainty, which will be more important later, when they go down to 1 salary.

LOC gives flexibilty, so long as you are not tempted by the 'Available Funds $100,000' on your statement.

Also, 5 year rates are lower than 2 yr at the moment.

My 2c

cube

[Rolf]

It is always better to pay off the loan instead of saving - she would basically be saving at the loans interest rate rather than what she can get from a savings account.

NOTE: If she has any PPOR borrowing she should make sure she pays that off before any IP borrowings.

If the difference between fixed and floating rate is assumed to be 1.5%, then she would need to have enough available funds on the LOC (on average) to make the interest payments on the remaining balance lower by that same amount.

To calculate what the average balance on the LOC should be in order to break even with a $300k loan on a fixed rate, simply divide the fixed rate with the LOC rate.
If the fixed rate is say 7.8% and the LOC rate is (7.8% + 1.5%) = 9.3% it comes to:

LOC average balance % = 0.078 / 0.093 = 83.9%

So she must make sure she is able to keep an average deposit in the LOC of (100% - 83.9%) = 16.1% of the LOC limit.
If there is $6-$8k sitting in the account we therefore get a break-even LOC limit of $37k-$49k.

Any LOC limit under this will enable her to save compared with having a fixed rate for the entire amount.

[CJ]

She gets approx $14K each month (before tax) but as a contractor probably pays tax once a year and ...

Haven't checked the rules in a while but she should probably be paying tax in three equal instalments during the year on the 4,8 and 12 month based on 1/3 of the previous years income (unless it is her first year of earning in NZ).

Make sure she has the right advise on this as if she doesn't, she might get a nasty shock at the end of the year (IRD interest rate is above 10% for underpayments).

[donna]

She's probably got a limited company and so is adhering to the tax rules for companies etc.

Cheers,

Donna

[MJU]

Another way to look at things?

Rather than look at the price of everything, have a think about the interest rate exposure your mate wants Donna.

If she is going to do the family thing in a few years, how about being risk adverse in years 3 through 5, and looking at a longer term mortgage.

In years three through five there may be a more limited opportunity to weather an interest rate shock.

Would you agree that a neutral strategy would have one fifth of the principal repricing every year?

Perhaps a not so popular way to think about things?

[donna]

Update -

Okay she has taken a $60K LOC with a 1 year fixed rate loan for $140K and her total borrowings was $200K not $300K as I thought.

So in 12 months time she hopes to have gotten the $60K paid off and then she'll go for a longer term fixed on the $140K.

Not a bad decision - as she can probably clear the $60K in 12 months and then going forward the tenant will pay her remaining mortgage off while she pumps out babies .

Cheers,

Donna

[CJ]

She's probably got a limited company and so is adhering to the tax rules for companies etc.

I assume this was a reply to my post. Again I say get professional advise!!!

The provisional tax rules apply to everyone (unless the total amount owed for the year is under $2,500 which is why most people dont know about it). With companies though, there is also a 5% uplift.

Unless she is in her first year, she will have to pay prov tax based on prior year (unless prior year is less than $2,500 and she owes more than this per month).