Large assets such as real estate will almost certainly be funded with a loan. Some investors also see value in borrowing to purchase more liquid assets such as shares. Before you finalise your loan you should consider how you are going to fund the loan and how this will affect your cash flow.
The following are important decisions:
- Deposit
- Loan Type
- Length of Loan
- Interest Costs
Shortly we will be introducing Financial Mappers Free, at which time you can register and create financial plans of up to 5 years. This will give youaccess to a set of Excel Tools where you will find calculators to test the various elements of your loans.
Deposit
The size of your deposit will determine your Interest Costs where the Loan Amount, Length of Loan and Interest Rates are the same.
In the following table, there are four loans with deposits ranging from 20% to 5%.
In the above example, you can see that the interest costs rise as the deposit is reduced.
In addition, the monthly payments rise as the deposit is reduced.
In terms of cash flow, if you can increase the deposit, both monthly payments and total interest costs will be reduced
Loan Type
The loan format can be an Interest Only Loan, a Principal and Interest Loan or a combination of the two, commencing with the Interest Only portion first.
In terms of cash flow, the Interest Only loan, as the name suggests only pays the interest due on the loan, leaving the borrower to repay the total capital at the end of the loan. One common strategy is to pay Interest Only while the asset is held and they sell the asset to capture the profits made by capital growth. Capital Gains Tax would be due when the asset is sold.
A Princiapal and Interest Loan makes payments of an equal value for the length of the loan, with the interest component reducing as the loan is repaid. Where the interest is tax deductible, the value if this feature reduces over time. However, at the end of the loan, the asset is held outright and the income from the asset has no loan obligations.
Length of Loan
By increasing the length of the loan, the monthly cashflow is reduced, however, the interest cost is increased. Each person will need to find a balance between the cost of monthly payments and the interest costs. One option may be to take a longer loan but make additional payments when you have the cashflow to facilitate. (Make sure there are no penalties for making additional payments)
Interest Costs
Interest costs are dependent on:
- The type of loan
- Security provided
- Loan to Value Ratio (LVR)
Interest Only loans will usually have a higher interest rate than a similar Principal and Interest Loan.
The lender will assess the security provided for the loan. Hard assets such as real estate are more secure than a person with a high income by no hard asset to back the loan. Therefore, the interest rate will be less, than that of an unsecured loan. It should be remembered that if you offer your home as security for a loan, and you are unable to meet your loan obligations, you may lose your home.
The greater the deposit and the lower the Loan to Value Ratio (LVR). Low LVR’s are likely to attract a lower interest rate.
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Glenis Phillips SF Fin – Designer of Financial Mappers and Advice Online
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