Does the Bulletproof Investing approach stack up in a high interest rate environment?
The answer is yes. In fact, the interest rate I paid on my first investment property was 6 per cent.
I’m dedicating the blog over the next two weeks to demonstrate why the approach still works with rising interest rates; Part 1 (this week) will deal with interest rates in the context of using a ‘cash’ deposit, Part 2 (next week) will deal with interest rates in the context of using an ‘equity’ deposit.
The Reserve Bank of Australia cash rate today is 1.85 per cent. Investors with an interest only loan will typically pay 2.5 per cent above the cash rate. Therefore, the typical investment loan today will cost you 4.35 per cent per annum in interest.
That’s not a high interest rate. It’s high compared with the emergency low interest rates of the pandemic, but not high in a historical context.
The pre-pandemic 10-year average ‘cash rate’ is 2.5 per cent (meaning investors pay 5 per cent). The 20-year average of the cash rate is 4 per cent (meaning investors pay 6.5 per cent). In other words, the current cash rate is still below the 10 and 20-year average.
In Bulletproof Investing, I talked about turning a $115,000 investment (20 per cent deposit, plus costs) into $600,000 within a 10-year period:
The above example works out to be a return of 17 per cent per annum. Or, in dollar terms, your $115,000 investment is returning you $48,500 per year. It’s not the only way to build wealth, but it’s the safest and best way I know.
However, it’s also important to consider your cash flow. That’s where interest rates come in.
In this same example as above, you would have borrowed $400,000 (80 per cent of the property value). In Bulletproof Investing, I used 4 per cent as a conservative interest rate at the time.
For the purpose of this exercise, let’s work out the numbers based on interest rates increasing to 6 per cent, which would be the case if the cash rate increased to 3.5 per cent (pretty much double what it is now, and just under the 20-year average):
The property is costing you $9,000 per year to hold, or roughly $175 per week.
However, you get some of that back as a tax refund as a property investor.
If, over the period of the financial year, the expenses on a specific investment (here, property) exceed the income generated by that investment, the difference (the ATO call it a ‘loss’) can be subtracted from the owner’s personal income, resulting in a tax refund.
When it comes to this example, if you receive net rent of $15,000 (after holding costs) and the property costs you $24,000 in interest, your ‘loss’ is $9,000.
At tax time, the Australian Taxation Office (ATO) will subtract the $9,000 loss on your investment property from your gross income. So, say your income is $80,000, you would only pay tax on $71,000 (i.e. the ATO refunds the tax you shouldn’t have paid).
The ATO would refund you $2,925. This means that, technically, the property has only cost you $6,075 to hold throughout the year (i.e. $9,000 less the $2,925 returned in overpaid tax). Down to $117 per week.
You also receive a deduction for the depreciation of the house. You will typically be allowed to depreciate $10,000 to $15,000 per year of the house cost over the first 10 years. What this means is you get to treat that depreciation amount as a tax deduction, so you’ll get a portion of it back as a tax refund even though you technically haven’t ‘paid’ for it (often referred to as a paper loss).
In this example, using a depreciation amount of $10,000, you would get a further tax refund of $3,250. This means the property is costing you $2,825 per year to hold after tax deductions. Down to $54 per week.
If you’ve done your research, the property is growing in value – your $115,000 investment is growing by $48,500 per year, much more than the $2,825 you are contributing to hold the property.
Personally, I don’t think interest rates will get to 6 per cent. If they do, I don’t think they will stay there for long. The long-term average interest rate on a loan will be between 4 and 5 per cent. However, even at 6 per cent, the approach works.
Finally, interest rates will increase where we have inflation. Where we have inflation, rents will increase too. Therefore, any increase in interest will at least partially be offset by an increase in rent. We’re seeing that today with rents growing by 9.5 per cent in the last 12 months.
This will reduce the cost required to hold the property over time.
As I said, it’s not the only way to build wealth, but it’s the safest and best way I know. And it works in low and high interest rate environments.
Does it work as well if you borrow the deposit from equity on your home? I’ll deal with that next week.
