Negative gearing disguises short-term impact of rate changes on investors
Property investors feel the effects of interest rate changes just as much as home owners do, although that impact may be disguised in the short-term by negative gearing.
Investors receive a tax deduction on mortgage interest expenses, so paying more interest on an investment property loan may not seem as bad as when rates rise on the loan that funds the family home. A bigger interest bill means a bigger tax deduction, after all.
But interest rate increases do hit the bottom line of investment returns. Higher costs, without accompanying rent increases, reduce the income the investor receives each year. This means the investment must achieve a higher capital gain to produce the same total return.
Accounting firm, HLB Mann Judd has crunched some numbers for Property Observer that demonstrate the effect of interest rate rises on a fairly typical property investment.
The property in the example is worth $465,000 and achieves a weekly rent of $400. An investor buys the property with a loan of $418,500 (having paid for 10% of the property in cash). The mortgage is taken over 25 years with monthly repayments. In the example, the investor has decided to repay the principal as well as interest.
Loan details | |
Property Value | $465,000 |
Loan Amount | $418,500 |
Annual Interest Rate | 5.1% |
Term of Loan (years) | 25 |
Repayment Frequency | Monthly |
The property generates an annual rental income of $20,800 and there are no periods of vacancy throughout the year.
Annual expenses total $6,306.
Estimated Annual Income | Estimated Annual Expenses | ||
Rental income (at $400/wk) | $20,800 | Strata Levies ($470/qtr) | $1,880 |
Council Rates ($270/qtr) | $1,080 | ||
Water Rates ($160/qtr) | $640 | ||
Management Fees (5.8%) | $1,206 | ||
Repairs & Maintenance | $1,000 | ||
Landlord Insurance Premium | $500 | ||
Total Income | $20,800 | Total Expenses | $6,306 |
Case study – mortgage rate 5.1%
In the first case, the interest rate on the loan is the Reserve Bank of Australia’s indicator rate for a discount variable mortgage, current as of May 2014, of 5.1%.
At that rate, the investor pays $2,471 a month for the mortgage, or $29,651 over the year. This comprises of $21,147 in interest and $8,505 in principal repayments.
Mortgage Repayments (at 5.1%) | |
Monthly Repayments | $2,471 |
Yearly Repayments* | $29,651 |
*Comprised of : | |
Annual interest repayments | $21,147 |
Annual principal repayments | $8,505 |
Total cost of loan | $741,286 |
Total interest paid | $322,786 |
That means the property generates a taxable loss of $6,653 for the year. Taking into account the principal repayments, the property has generated an annual cash loss of $15,158.
The principal has reduced by $8,505 so there is $409,995 outstanding on the mortgage.
Taxable profit/loss | |
Estimated Annual Income | $20,800 |
Estimated Annual Expenses | -$6,306 |
Annual Interest Repayments | -$21,147 |
Annual Taxable Loss | -$6,653 |
Annual Principal Repayments | -$8,505 |
Annual Cash Loss | -$15,158 |
Case study – mortgage rate 5.6%
Say the interest rate was 0.5 percentage points higher at 5.6%, while rent and other expenses on the property remain the same.
Repayments on the loan are $2,595 a month, or $31,140 over the year. The amount of interest paid increases to $23,235 for the year. However, the amount that is repaid off the principal reduces to $7,905.
Mortgage Repayments | |
Monthly Repayments | $2,595 |
Yearly Repayments* | $31,140 |
*Comprised of : | |
Annual interest repayments | $23,235 |
Annual principal repayments | $7,905 |
Total cost of loan | $778,503 |
Total interest paid | $360,003 |
The annual taxable loss on the property increases to $8,742. The total cash loss is $16,647 and there is still $410,595 outstanding on the mortgage.
Taxable profit/loss | |
Estimated Annual Income | $20,800 |
Estimated Annual Expenses | -$6,306 |
Annual Interest Repayments | -$23,235 |
Annual Taxable Loss | -$8,742 |
Annual Principal Repayments | -$7,905 |
Annual Cash Loss | -$16,647 |
Case study – mortgage rate 6.1%
If the mortgage interest rate was higher again, at 6.1%, repayments on the loan would go up to $32,664 for the year.
Mortgage Repayments | |
Monthly Repayments | $2,722 |
Yearly Repayments* | $32,664 |
*Comprised of : | |
Annual interest repayments | $25,326 |
Annual principal repayments | $7,339 |
Total cost of loan | $816,612 |
Total interest paid | $398,112 |
The taxable loss for the year would be $10,832 and the cash loss, after principal repayments would be $18,171. Just $7,339 would have been paid off the principal, leaving a $411,161 outstanding on the mortgage.
Taxable profit/loss | |
Estimated Annual Income | $20,800 |
Estimated Annual Expenses | -$6,306 |
Annual Interest Repayments | -$25,326 |
Annual Taxable Loss | -$10,832 |
Annual Principal Repayments | -$7,339 |
Annual Cash Loss | -$18,171 |
After tax comparison
In the first example, the investor made a taxable loss of $6,653 and ended the year with $409,995 outstanding on the mortgage.
Let’s assume the investor’s annual taxable income (from employment and other sources) is $100,000. In the example where interest rates were 5.1%, the taxable loss on the property reduces the investor’s taxable income to $93,347 for the year, cutting the investor’s tax liability for the year by $2,462 and leaving them with an after-tax income of $70,862.
That means the after-tax cost of the investment (not including the principal repaid) is $4,191 and the total after-tax cash loss including the principal repaid is $12,696.
In the second example, the investment’s after-tax cost is $5,507 and the total after-tax cash loss is $13,412. The investor is $1,316 worse off at the end of the year in this case than if the interest rate was 0.5 percentage points lower.
In the third example, the after-tax cost is $6,824 and the cash loss after tax is $14,163. The investor is $2,633 worse off at the end of the year than when the interest rate was 5.1%.
Interest rate changes have a real impact on the returns from investment properties. To recoup higher interest charges, investors have a choice to increase rent, cut costs elsewhere (which might not be practical or possible), or cross their fingers for greater capital gains to compensate.
