Why investors should be wary of lines of credit: Kevin Lee
Investors who aren't good at managing money could find a line of credit (LOC) to be their biggest mistake: helping them to get in way over their heads financially. LOC's are an exercise in compounding interest - and work really, really well; for the bank!
Although the interest rate on an LOC appears competitive compared to a credit card - used incorrectly it often becomes a massive financial problem.
This is the biggest downside investors should be wary of - LOC's allow you to capitalise the interest until you reach the limit (or 90% of the credit limit). Many people don't think this through; capitalising the interest fools people into a false sense of security, but in fact it means that the interest incurred is simply being added to the amount already drawn down.For example, if you borrow $250,000 via a LOC and interest for the month is $1500, instead of being required to pay the $1500 into the loan, the balance simply becomes $251,500. Repeated monthly that $1500 interest component grows: maybe only by $10 to $1510 the next month, but by the end of the first year that monthly interest component will be well over $1600.
If you are using your line of credit for personal purchases, you can see how easily this can become dangerous. Ignoring the debt by allowing the interest to capitalise will directly affect your ability to expand your portfolio.
Tip: you should budget to repay your LOC in full over 10 years.
Question yourself if that timeframe seems impossible; if you can't pay it off don't be deluded into believing its helping you get where you want to go.
Smaller amounts like $5,000 or less should be paid back within two years; three years is realistic for amounts such as $10,000.
Never forget that growing your portfolio is your priority and every decision you make must contribute to its growth. Therefore using a line of credit to purchase depreciating assets such as cars is nothing more than a step backward in your journey to financial freedom.
Of course investors often access funds from a LOC to fund renovations or repairs needed to improve their investment property, potentially improving the rental return and value. That's OK - as long as a plan is in place to pay that debt off over a given timeframe.
If you're a home owner wanting to invest, beware of using a LOC attached to your home - you should seek advice from your financial planner and/or accountant. Get it wrong and you'll be sorry!
Don't mix business with pleasure, park your pay as you go income in your owner-occupied property offset account to save interest on your owner-occupied debt. Don't park your income in the LOC.However if like so many people - you've already mixed business with pleasure - see your adviser as soon as possible to help get you back on track.
What's all the fuss? Mixing business expenses (investment) with pleasure (personal) means you will lose tax deductibility status on some of the loan. This will ultimately also increase your accountancy costs substantially.
Lines of credit can be useful for consolidating other debts into your mortgage, however they are not for everyone.
Before you consider a line of credit ensure that you have a strict budget plan in place to stay within your financial limits.
Don't become dependent on your line of credit, it will ultimately do you more harm than good - often slowly and without you noticing it.
Kevin Lee is the property investment expert and buyer's agent at Smart Property Adviser.
Kevin specialises in helping investors identify and acquire positive cashflow properties that generate high rental returns, enabling his clients to grow their portfolios.
Kevin's free report "How To Turn Your Negatively Geared Property Into A Positive One In 3 Steps - Without Selling" is available at www.smartpropertyadviser.com.au.
