Does the Bulletproof Investing approach stack up in a high interest rate environment?
The answer is yes, and I’ve dedicated the last two weeks’ blogs to demonstrating why the approach still works with rising interest rates; Part 1 (last week) dealt with interest rates in the context of using a ‘cash’ deposit, Part 2 (this week) will deal with interest rates in the context of using ‘equity’ as a deposit.
‘Equity’ is the difference between the property value and the debt you owe on that property.
Last week I talked about investing $115,000 in cash (20 per cent deposit, plus costs) and how, doing so, meant a property would cost you $2,825 per year to hold if interest rates rose to 6 per cent.
However, you could instead invest the $115,000 by taking out an ‘equity loan’ against your own home (or an investment property) instead of using cash.
It means instead of borrowing 80 per cent of the property value, you end up borrowing 100 per cent of the property value, plus the costs of purchase.
The benefit of putting in equity, rather than cash, is that it allows you to buy a property without having to have the cash saved up, and ultimately gets you a better return on your investment (because you’re not actually investing any cash).
However, it’s also important to consider your cash flow. That’s where interest rates come in.
As we did last week, 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 $15,900 per year to hold, or roughly $306 per week.
However, you get some of that back in the form of 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 $30,900 in interest, your ‘loss’ is $15,900.
At tax time, the Australian Taxation Office (ATO) will subtract the $15,900 loss on your investment property from your gross income. So, say your income is $80,000, you would only pay tax on $64,100 (i.e. the ATO refunds the tax you shouldn’t have paid).
The ATO would refund you $5,168. This means that, technically, the property has only cost you $10,732 to hold throughout the year (i.e. $15,900 less the $5,168 returned in overpaid tax). Down to $206 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 $7,482 per year to hold after tax deductions. Down to $144 per week.
If you’ve done your research, the property is growing in value – by $48,500 per year – from no cash investment, and much more than the $7,482 you are contributing to hold the property.
The approach still very much works at 6 per cent, with cash or equity as your deposit investment.
As I said last week, I don’t expect interest rates to get to 6 per cent and, if they do, they won’t stay there for long. I think 5 per cent is a more realistic medium to long term interest rate. It’s also worth noting that interest rates and inflation are linked, meaning high interest rates leads to high wage growth and inflation, and therefore increasing values and rents.
This will reduce the cost required to hold the property over time.
One last point to consider.
The Australian Tax Office allows property investors to file what’s called a tax variation. This effectively means rather than waiting until the end of the year for their tax return, investors can apply to get their refund back by paying less tax throughout the year.
Let’s use the above example of someone who earns $80,000 and effectively claims $25,900 in tax deductions at the end of the year ($15,900 in ‘cash loss’, plus $10,000 for depreciation ‘paper loss’) compared with someone earning the same income, but without the property deductions:
Instead of getting $8,417 in tax refund at the end of the year, the property investor can opt to instead receive $162 in extra income each week as a result of their employer paying less withholding tax to the ATO on their behalf.
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.
