If you’re actively looking to buy a new property, as a home or an investment, sorting out your finances is an important part of the process. This means becoming acquainted – or reacquainted – with some potentially intimidating financial jargon. Here’s a straightforward explanation for three of the trickiest property investment terms.
Debt recycling takes your home loan debt, which isn’t deductible, and converts that debt into a tax-deductible investment loan. It’s best suited to those that have an existing mortgage, but would like to make a second investment in property or shares. Ideally, the investment loan will help you pay off your mortgage and at the same time increase your net worth. In the meantime, you have a tax-deductible debt, which is cheaper to service than a debt with no deductions. The investment loan may help pay off your mortgage and increase your net worth.
You’ll want to have:
*Discipline, as all of the investment earnings should go back into the property loan to ensure that the mortgage is paid off;
*Earn enough to get the most out of those tax deductions (and a stable job to ensure you can meet repayments);
*Annual visits to an accountant to understand your deductions such as costs interest and depreciation; and
*Free cash flow to pay the investment debt and the home loan.
Debt recycling sound too good to be true? There are things you should consider before you take the leap:
*As you increase your property holdings you have to be in it for the long haul – a time frame of at least seven years is recommended to ride out the ups and downs of the market;
*You may increase your risk to market volatility;
*If you decide to sell your investment, you will have to pay tax on your capital gains.
Debt consolidation involves merging all your debts, such as your mortgage, credit-card debts, utility bills or student loan into one monthly repayment. While debt recycling attracts people who are investors, consolidating your debts can be a good choice for those who are struggling to pay off their loans.
This type of loan can help you secure a lower interest rate and lower your monthly payments. It’s also a loan that’s useful for paying off debts that aren’t tied to an asset. Not a great choice for short-term debts.
Debt consolidation can cost more in the long run. If you have a short-term debt, like a personal loan, paying it off over a longer period may end up costing you more in interest than paying a debt over the shorter term.
If you’re undisciplined with money in the first place, consolidation could make your problems worse. Because even if you transfer your credit card balances onto your home loan, or personal loan, there’s nothing to stop you from continuing to use your credit cards.
And if your debts are consolidated with your property loan, missing out on repayments could end with you losing your home, depending on how much equity you have in your property. If debt consolidation is something you would consider, make sure that your debt consolidation company or credit provider is listed with the Australian Securities and Investment Commission (ASIC).
Debt-to-income ratio (DTI)
A debt-to-income ratio compares your property loan repayments to your income. It’s a crucial term in the mortgage and lending industry as it shows lenders just how likely you are to repay your loan. A healthy DTI ratio reassures lenders that you’re going to repay the loan. Lenders study two types of DTI ratios when you apply for a mortgage:
1. The front-end ratio (or housing ratio) – This is the percentage of your income that goes towards your housing expenses, including your mortgage payments and homeowner’s insurance.
2. The back-end ratio – This is the percentage of your income that’s necessary to pay off your housing ratio (above) as well as your monthly debts, like credit card bills and student loans. Be aware: If your DTI ratio is too high it may be hard to get financing.
So now we’ve unpacked three of the trickiest home loan terms, you should feel confident talking the language of lending: Debt consolidation, debt recycling and DTI.