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Investors should be wary of lines of credit
Topic Started: 23 Sep 2013, 10:26 PM (1,989 Views)
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Why investors should be wary of lines of credit: Kevin Lee

By Kevin Lee
Monday, 23 September 2013

Investors who aren't good at managing money could find a line of credit (LOC) to be their biggest mistake: helping them to get in way over their heads financially. LOC's are an exercise in compounding interest - and work really, really well; for the bank!

Although the interest rate on an LOC appears competitive compared to a credit card - used incorrectly it often becomes a massive financial problem.

This is the biggest downside investors should be wary of - LOC's allow you to capitalise the interest until you reach the limit (or 90% of the credit limit). Many people don't think this through; capitalising the interest fools people into a false sense of security, but in fact it means that the interest incurred is simply being added to the amount already drawn down.

For example, if you borrow $250,000 via a LOC and interest for the month is $1500, instead of being required to pay the $1500 into the loan, the balance simply becomes $251,500. Repeated monthly that $1500 interest component grows: maybe only by $10 to $1510 the next month, but by the end of the first year that monthly interest component will be well over $1600.

If you are using your line of credit for personal purchases, you can see how easily this can become dangerous. Ignoring the debt by allowing the interest to capitalise will directly affect your ability to expand your portfolio.

Tip: you should budget to repay your LOC in full over 10 years.

Question yourself if that timeframe seems impossible; if you can't pay it off don't be deluded into believing its helping you get where you want to go.

Smaller amounts like $5,000 or less should be paid back within two years; three years is realistic for amounts such as $10,000.

Never forget that growing your portfolio is your priority and every decision you make must contribute to its growth. Therefore using a line of credit to purchase depreciating assets such as cars is nothing more than a step backward in your journey to financial freedom.

Of course investors often access funds from a LOC to fund renovations or repairs needed to improve their investment property, potentially improving the rental return and value. That's OK - as long as a plan is in place to pay that debt off over a given timeframe.

If you're a home owner wanting to invest, beware of using a LOC attached to your home - you should seek advice from your financial planner and/or accountant. Get it wrong and you'll be sorry!

Don't mix business with pleasure, park your pay as you go income in your owner-occupied property offset account to save interest on your owner-occupied debt. Don't park your income in the LOC.

However if like so many people - you've already mixed business with pleasure - see your adviser as soon as possible to help get you back on track.

What's all the fuss? Mixing business expenses (investment) with pleasure (personal) means you will lose tax deductibility status on some of the loan. This will ultimately also increase your accountancy costs substantially.

Lines of credit can be useful for consolidating other debts into your mortgage, however they are not for everyone.

Before you consider a line of credit ensure that you have a strict budget plan in place to stay within your financial limits.

Don't become dependent on your line of credit, it will ultimately do you more harm than good - often slowly and without you noticing it.

Read more: http://www.propertyobserver.com.au/news/why-investors-should-be-wary-of-lines-of-credit-kevin-lee/2013092265148
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Trojan
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I think LOC's are very useful if you know how to use them. But if you don't use them properly then I agree, you could get yourself into a lot of trouble.
Likewise with credit cards.

p.s. Kevin Lee is my mortgage broker.
I put trolls and time wasters on my ignore list so if I don't respond to you, you are probably on it ....
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Foxy
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Zero is coming...

Credit is like heroin, does a great job when it's needed but man don't get hooked on it.
Peter from Gnarabup
:pop:
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those
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Trojan
24 Sep 2013, 12:48 AM
I think LOC's are very useful if you know how to use them. But if you don't use them properly then I agree, you could get yourself into a lot of trouble.
Likewise with credit cards.

p.s. Kevin Lee is my mortgage broker.
Could you give an example of a good use for one?
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miw
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those
24 Sep 2013, 02:55 AM
Could you give an example of a good use for one?
Anything with an IRR higher than the interest rate.
The truth will set you free. But first, it will piss you off.
--Gloria Steinem
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those
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miw
24 Sep 2013, 03:38 AM
Anything with an IRR higher than the interest rate.
But aren't LOC accounts usually marketed to people with mortgages and equity and aren't the rates always (or generally) higher than the mortgage rate?

So why not just borrow more within the main mortgage account?
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Trojan
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those
24 Sep 2013, 02:55 AM
Could you give an example of a good use for one?
Sure.
I used a LOC to capitalise all the expenses of my investment property while it was negatively geared (but not the interest which was always paid first by the rental returns)
That way, my salary was focused on paying off my own PPOR (non tax deductible debt) first without having to use it to subsidise my investment property (deductible debt)

Edit for clarity:
1 PPOR and 1 investment property
Regular home loan with offset account for PPOR
IO loan with an attached LOC for investment property

All income (salary, rental income) goes into my offset account
All loan repayments (PPOR and investment property) comes out of the offset account
All other expenses (repairs, council rate, etc) come out of the LOC
The ATO has a ruling against capitalising interest expenses but in my case, I wasn't capitalising the interest expenses ... they were being paid from my offset account. I was merely capitalising other expenses.
When the investment property became positively geared (rising rental returns and falling interest rates) any extra amount where the rent exceeded the repayments was effectively directed into reducing my PPOR loan.
An extra advantage keeping the LOC seperate to the investment property loan is if the ATO decides to change their ruling in the future, I can quickly pay down the LOC without it having tainted my investment property loan.



those
24 Sep 2013, 09:14 AM
But aren't LOC accounts usually marketed to people with mortgages and equity and aren't the rates always (or generally) higher than the mortgage rate?

So why not just borrow more within the main mortgage account?
My LOC was taken out before the GFC and is the same interest rate as my regular home loan.
Edited by Trojan, 24 Sep 2013, 12:27 PM.
I put trolls and time wasters on my ignore list so if I don't respond to you, you are probably on it ....
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Sydneyite
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those
24 Sep 2013, 09:14 AM
miw
24 Sep 2013, 03:38 AM
Anything with an IRR higher than the interest rate.
But aren't LOC accounts usually marketed to people with mortgages and equity and aren't the rates always (or generally) higher than the mortgage rate?

So why not just borrow more within the main mortgage account?
They are usually only 20-25 basis points or so higher than the best discounted SVR you can get on your "regular" mortgage, and sometimes not even that. Eg my current LOC rates are 5.33%, vs 5.08% on my "regular" loan account.

You also asked for good uses for LOC - I use/used LOCs secured by my house to fund a share portfolio and a business investment. They enable the transactions related to a particular investment to be segregated from each other, and each particular account can be in a a single name (eg, one for me, one for my wife etc if we want), which is all good for tax purposes - you cannot do this if you just maintain a single mortgage loan that you originally used to buy your house, especially if in joint-names. All this with the benefit of very low interest rates due to the house being the security, no margin calls like with margin loans and so on.

Eg, for the share portfolio LOC, all share purchases are always done with fund "borrowed" from the LOC. I can do as I please with dividend proceeds. Any share sale proceeds flow back into the LOC first. This means 100% of the interest on *that* account is always tax deductible, with no ambiguity - remember deductibility is determined based on what your borrowed funds were used for in the first instance.

Then there are other advantages - instead of paying off the LOCs with income from other sources, PPOR mortgage was obviously paid down to zero first. Then spare cash is/was funnelled into high interest rate savings accounts / TDs in my wifes name (who is on a lower marginal tax rate than me), resulting in after tax interest income on that cash *higher* than the after tax cost of the LOC account interest. Try doing that with your regular PPOR mortgage! :oo: As long as we can pull that one off, I will never pay those LOC accounts off - in fact, the bigger they get, the more after-tax interest rate "arbitrage" profit we make, on top of income/profit from the investment originally made with the account funds. Note there are some minor risks with this strategy, and takes a long term plan to get to the point where it starts to yield reasonable amounts. But if carefully managed it works well.

The Australian tax system is wierd beast - it actually makes it truly profitable in this situation to take on and maintain the highest level of "paper" debt possible! :re: LOCs play to these strategies perfectly.

Edited by Sydneyite, 24 Sep 2013, 12:36 PM.
For Aussie property bears, "denial", is not just a long river in North Africa.....
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foxbat101
24 Sep 2013, 01:26 AM
Credit is like heroin, does a great job when it's needed but man don't get hooked on it.
Peter from Gnarabup
:pop:
Well that's an interesting opinion. How many times a month do you need heroin?
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peter fraser
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1. A number of lenders offer their LOC products at the same rate as their other products.

2. Anyone who doesn't handle credit well can just as easily destroy themselves on a P&I loan. They don't need an LOC to do that.

3. The MAIN issue with an LOC is that like an overdraft it can be called in, unlike a P&I or an I/O loan. That's unlikely to happen, but it can.



Any expressed market opinion is my own and is not to be taken as financial advice
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