Finance Roll

Many people live in a world where they believe that debt is bad. I used to. Debt is only bad if it's not managed properly, otherwise it's not just good - it's great.

The text below will probably be stating the obvious to some but I hope will be of value to many of you. There will be two themes; [1] Leverage through debt and [2] How and offset mortgage can work for you. This article assumes some basic knowledge of personal finance and the terms used within it.

1. Leverage through debt.

We are going to assume here that we are going to invest money into property. the main assumption that the reader must make in order to make this work for you is that you have the cash to finance a deposit on the property.

Let's say that you have £10,000 that you can invest. Let's also say that you have credit rating such that you can secure a mortgage with a 90% LTV. Lastly, for sake of simplicity, let's assume that purchasing costs total £5000 which you can capitalise. What this means is that someone will lend you £100,000, if you put down £10,000. Given that we've got costs of £5,000 it leaves us £95,000 to buy a property.

Assume now that you've bought your property, you are renting it out and the rent covers mortgage interest and other costs, i.e. you are cash flow neutral. Roll the clock forward 1 year and let's assume that the value of your property has appreciated by 10% to £104,500. You decide to sell. You sell at £104,500 with £5,000 in selling costs leaving you with £99,500. Now, you owe £95,000 to the bank leaving you with £4,500.

So here's leverage. you've just made £4,500 on an investment of £10,000. That's a 45% return. Without the leverage, let's say you purchase the property for your cash. You would have had a return of £4.7%. Which would you prefer?

It's important that you read the above in conjunction with the assumptions at all times. The reality of property investment can be different but this principle always applies.

Notes:

a. You will see many adverts, often in the weekend papers, offering you a free seminar on how to borrow money with no deposit. I've never looked into any of these but I do believe that you get what you pay for. Hence if you're borrowing money with no deposit then you are paying for it in someway regardless of how transparent this is.

b. You will not rent your property 100% of the year so either, you'll need to increase rent to cover cashflow during vacant periods or take a hit to your cashflow.

c. If you take a hit to your cashflow this doesn't have to be a bad thing as long as it's managed. At the end of the day this just comes out of your profits. What you need to ensure is that you have the cash to ride the troughs.

2. How an offset mortgage can work for you.

Offset mortgages are great for those who have some equity in their property. For purposes of borrowing, an offset mortgage is essentially just a big overdraft secured on your house. Remember how I said above that you couldn't borrow money for nothing, well there's an exception to every rule and here it is.

Let's say that you bought your house with a classic 25% deposit. Now go out and re-mortgage, for an interest only offset mortgage product, for more than 75% - let's say 90%. You've just released 15% of the value of your house as cash - well done! Having read the first part of the blog, you know want to invest this money in property to achieve some leverage on this newly found cash - good choice. Having considered your options you're concerned that through rental you won't cover your monthly cashflow and you don't have cash to support this. This would mean that you would default on your interest payments on the 15% extra in equity that you've just borrowed. (note: I'm assuming you could afford your mortgage interest repayments at 75% prior to re-mortgaging!).

Here's what you do. Let's say your house is worth £200,000 and so 15% of this is £30,000. The next assumption that you will buy, rent and sell your investment property in a calendar year (just because it makes the numbers a little easier on the eye). Some more assumptions. The interest rate on your offset is 5% and on the property you're about to buy you'll need £5,000 to cover vacant time. Lastly, I'm not including costs in this example just for simplicity, you can always factor them in yourself if you're serious about this.

OK, now you can make some money.

1. Of the £30,000 that is available, take £23,500. This leaves £5000 to cover costs and £1500 annual interest on £30,000.

2. Use your £23,500 to secure 90% financing on a property and borrow £235,000.

3. Go and buy a property for £235,000

4. After 1 year, sell the property with 10% appreciation making £23,500 in profit.

General Notes:

I have simplified some statements and calculations in this article such that they are not 100% accurate. Despite any minor inaccuracies the magnitudes and principles remain the same, there is nothing deliberately misleading here. If you are to consider this seriously, you need to understand what goes into finder someone to rent your property, how much this costs (cost of acquisition), how much insurance is, how much you might pay in maintenance.

If you remember only one thing from this it should be leverage. Learn to obtain and manage debt so that you can exploit the risk giving you leverage