Maxing out Borrowing Capacity - What's Wrong?

Can someone tell me what's wrong with maxing out your borrowing capacity now rather than later? For example, if my borrowing capcity is $800k and I buy a property for $900k ($800k borrowed from the lender and 10% deposit), then how is this different to if my borrowing is still the same at $800k, but I buy a property for only $500k. I will still have some borrowing capacity up my sleeve for use later, but wouldn't you rather have bought a higher value property or multiple properties to max out the borrowing capacity, so you can get growth on a larger value than a smaller value? That is say, you are getting 5% growth, you would get 5% growth on the $900k value ($45k) than just the same growth on $500k ($25k). You are giving your $900k more time to grow this way. Obviously, as the value of the property portfolio increases and you pay down the debt, your serviceability improves and your borrowing capacity increases and you go again, but what's wrong with borrowing to the max at every single stage you can, maybe even staying at 80% all the time?

Does it have to do anything with yield at all, that is, do you reckon the yield on a $900k property is lower than 2 x $450k properties?

 

Other things being equal, yes your logic is correct, especially regarding the potential gains relative to the size of the leverage.

Also bear in mind rules can change, so your capacity of $800k today could be $400k tomorrow. I intentionally chose $400k as the example because it means yes your hypothetical $500k purchase couldn't be re-bought even if you sold it and wanted to buy it back for the exact same price. That's what happened to a lot of us post-APRA so it's a realistic scenario...a real life game of musical chairs (don't stand up!).

As far as yield goes, yes generally the rule of thumb is the higher you go the smaller the yield so buying 2 could be better (ignoring other factors like increased expenses), however that's irrelevant to your question...you could have bought both 2 x $450k properties at the same time.

 

Say you max out your borrowing capacity on one ip. What happens when you want a ppor?

 

Yup that's a genuine issue for those wanting to rentvest. I faced this issue myself when the APRA rules changed.

However now people are so limited in how much they can borrow I wonder if it's really worth worrying about. If he's got $300k left in serviceability...what is that really going to buy him? lol

But it's still a valid point to keep in mind.

 

Good point. I was thinking the same, but I am sort of thinking I "may" actually not need a PPOR at all. I am flirting with the idea that I can rent all the time. There are multiple benefits to this. I can stay in a very desireable location of my choice such as say Manly/Mosman/Coogee; a location that is close to the best schools for my kids (once I have them after finding a GF!), be close to lifestyle factors such as the beaches, CBD, etc. Another pro is that usually the rent in these most desirable places is lower than the mortgage you pay in these places. Why not rent where you live so you can choose the best locations, in other words, rentvesting? Also, isn't your loan on your PPOR considered a bad debt as it is not producing any income? The other side of the coin is that you are paying rent which goes to a stranger, but at least the rent in such nice locations is usually lower than the mortgage payments for these sort of places?

Of course, my future partner may want her own abode/nest and not rent a home to live in, so yes, I may not be able to rentvest forever.

 

A few things.
Ppor debt can be recycled. Ppor is cgt free. You will find that renting near the best public schools isnt easy, and it will only take one landlord who wants to move back in or doesnt want to rent to families with small kids to upend your life before you want ro buy.

and a single guy talking about renting forever usually gets a batful of reality in the head soon enough. When (if) you have a family, stability (and the ability to paint and put hooks in the walls) does seem more important.

but if you can do it, nothing wrong with renting and investing.

 

Yes, that's right - rules can change. APRA could tighten up their restrictions in the future and my borrowing could be a lot lower later, so why not just take advantage of easier lending policies and higher borrowing capacity now before it is too late and the rules are changed again? Also in my case, my personal situation could change as well. My salary is actually going to down in the near future. I am currently doing a FIFO (Fly-In Fly-Out) job where I am getting paid about $40k more, hence, my borrowing is at an all time high. Why not capitalize on this higher borrowing capacity while I have it? Once I head back to the city in a few months' time, my salary is going to go down and this will decrease my borrowing capacity severely. Why not take advantage of the sutiation while I can - leverage to the max while it is possible? The fear for most people seem to be that they may not be able to make mortgage repayments, but for me that's not an issue as I save about 80% of my income which is available for investing (single and no kids). I am just trying to see the other side before I use up all my borrowing capacity now as I have always heard not to borrow to your max.

 

Point noted.

 

Yup if the money is there, take it. It's the same concept behind equity releases - every time the market goes up extract the equity even if you have zero uses for it. Cause by the time you do, it may not be there any more (either the market goes back down, the bank rules change, our your personal situation changes...maybe you have a kid or something like that which massively impacts your borrowing).

 

The thing is I am planning to purchase a property in Western Sydney with property development potential. This usually doesn't come in the $450k range as I need a decent amount of land to do this. This is generally upwards of $700k value. So I was thinking buy a property with R2 (>650m2) or R3 (>550m2) in areas scuh as Oxley Park, St Mary's, Kingswood, etc., for a purchase price of upto say $850k, then sit on it for a few years, let the values rise, and then go into property development (duplexes or TH). This way I am manufacturing my equity instead of waiting for the market to grow. It is instant equity that I could get. I can't do all this at around the $450k mark as I won't decent sized land with that in Western Sydney; maybe in the Newcastle regiona I could though, but this will take a lot of time as I haven't researched this market at all (or I would have to get a BA to do it). Buying properties with future development potential costs closer to the $700k mark in Western Sydney, and if this is the case, then I will start to max out my borrowing capacity now.

 

If you make a good investment, being highly leveraged increases your return, but if it turns out to be a bad investment, the same applies.

Maximising your purchase price will increase the likelihood of you having to sell in event of a change to your circumstances (e.g. get a partner who wants to buy OO, lose your job, etc). Buying a $900k property is $36k of Stamp Duty plus ~$20k of selling costs if you need to sell. Diversifying with property investment is not as easy as with shares, but that doesn't mean you shouldn't consider it.

 

Paying down debt doesn't really improve borrowing capacity, it simply replaces one loan with another. The total borrowing capacity stays the same.

Most younger people I meet get increases in borrowing capacity via changing jobs and getting a salary increase.

Cheaper properties to tend to attract higher rent as a proportion of property value. A cheap rpoerty might rent for as much as 6% of the purchase price, whilst the more expensive property might only get about 3%. I've seen these sorts of numbers many times. Other holding costs don't scale the same however, so net yield might be a little different, it very much depends on the property and location.

It's worth noting that yield doesn't necessarily define a good investment. Ultimately capital growth is the biggest creator of wealth. Buy and sell strategies can leverage this very effectively.

 

I would say that paying down debt while retaining rental income does improve capacity, over time. Total capacity is improved because you retain existing rental incomes and as you add additional INV properties you also add additional rental income....

If I start with 500K of debt on an property producing $500 per week rent, and I can reduce that debt by lets say 50% to 250K my capacity should improve.

If I seek to borrow an additional 500K several years later for another INV property, and it also produces $500 per week rent, I would now be assessed for serviuceability against 750K of debt but with $1000 per week rent

Had I not paid down any debt, I would have been trying to borrow $1Million with $1000 per week rental income, rather than trying to borrow 750K with the same $1000 per week rental income ....

 

Not a developer so maybe others can provide more insight but if you're planning on developing your property in the future, how do you expect to fund it if you've maxed out your borrowing capacity and expect your income to go down in the future?

Similarly, it would make it difficult to refinance. If you have a 5 year interest only term and want to keep refinancing to extend that out, I can't imagine you'd be able to do so if you've maxed out and your serviceability decreases in the future. Could also be stuck with your lender with high interest rates if interest rates rise in the future.

Not saying it's a bad strategy as I'm doing the same (but with the expectation that my borrowing power will increase with salary bumps) but just some considerations.

 

Correct me if I am wrong, but I thought if you pay down your debt/existing loan committments, your mortgage repayments will decrease which improves cash flow and this increases your borrowing capacity.

 

The extra repayments reduce the time it takes to pay down the loan, not the monthly repayment amount. There are a handful of lenders who allow dynamic repayment reductions ( where repayments reduce if you pay off extra ) but it isn't common. Almost all loans are amortised over 25 or 30 years and extra repayments simply reduce the time it takes to pay them off. So your mortgage payments wont decrease.... they will just end sooner

Basically, if you wish to improve your borrowing capacity you need to generate more income. Base salary/wages are the best source of additional income as lenders accept 100% for servicing, typically . Bonuses and O/Time and commission and allowances are typically shaded, meaning most lenders accept 50-80% of that income source. Rent is also shaded. Lenders typically accept 70-80% of Gross Rent.

The other thing that helps is debt reduction... especially non income producing, non deductible debt reduction. Every extra dollar you can pay off faster has an impact...its slow and lacks wow factor, though, of itself. Really, what is required is a combination of ongoing, compounding debt reduction combined with increases to income ( salary, rent etc ) to move the needle over time.

Big increases in income can move the needle faster, and big debt reduction can do- but that will generally only be possible if you sell something to crystalise profits that can be used for that purpose, or you inherit money or have some other windfall .....aside from that there is no magic bullet - its a long, steady and consistent approach that pays dividends.

Paying P&I instead of IO is also helpful, because of the rules around "sensitised assessment /remaining P&I term" that lenders are required to use ( except a couple of non ADI's) The value of paying P&I is being disguised by ultra low rates at the moment, but as they move upwards in years to come the need for this will become clearer to many people...

Its why I like cash cows ( my particular poison is Dual Occ's ) . They allow you to hold assets that produce big surpluses each year, which can be used to either ;

Pay down PPOR debt ( non income producing, non deductible debt) faster OR
Pay down bad debt such as credit cards, personal loans, car loans, HELP debt etc- all massive chains around the neck of your borrowing capacity OR
Pay P&I on your investments - the extra cash flow makes P&I repayments far easier

All roads lead to the same thing ; you retire debt faster, which enhances your chances of borrowing more money sooner, which allows you to buy more cash cows sooner, which allows you to pay down even more faster, which enhances your chances of borrowing even more money sooner, which allows you to buy more cash cows sooner, which allows you to...... you see the point .

OR if you dont like that concept; inherit some money. win some money. earn lots more money

 

How do I expect to fund the property development? - that's exactly one of my questions in this thread - Large R2 Block vs Small R3 Block - Property Development

I don't plan to do any property development anytime soon after purchasing the property. I want to settle, maybe wait for 3-5 years, save a lot of money during this period, and then develop either a duplex or a couple of TH on this property. By then (say 5 years' time), I would expect my salary to have gone up again too. It's just in the immediate future (next few months) that my salary is going to go down. Also while I am waiting for the next 5 years, the value of my other property (also in Sydney in Schofields) should go up. With the value of this Schofields property going up (1st property), and the value of the new property (with development potential) going up (2nd property), plus with also saving for about 5 years; I should have enough deposit to put towards developing the property (2nd property). This should be more than enough deposit for the loan to construct the duplex, or I could even pay down the loan a bit, reduce the debt, reduce my payments/committments, and increase my borrowing capacity that way. I am not 100% sure of my strategy yet, but open to suggestions, and that is why I am here on PC. Some of these are just ideas and can be undone if APRA or lending policies or council regulations change drastically.

 

Assume interest rates are all the same and there's no tax benefits involved.

If you use $100k of your savings to pay down $100k on a loan and you do a limit reduction on that loan, you'll increase your future borrowing capacity by $100k.

Or you could have just put the $100k cash towards the future project. Your net borrowing capacity hasn't changed at all.

When you introduce other variables such as tax deductibility and differing interest rates, this would change the equation either way. I've seen examples where people have paid off debt and their borrowing capacity actually was less than what they previously had.