What is Interest Capitalisation And Is It A Good Investment Strategy? (Ep320)
What is interest capitalisation and is it a good investment strategy to grow your portfolio and generate a passive income. Is it too good to be true?
What is interest capitalisation? And is it a good strategy to grow your property portfolio and increase your passive income?
Hey, I’m Ryan from onproperty.com.au, helping you find positive cash flow properties. Interest capitalisation, in basic terminology, is the process of adding interest on to a loan instead of paying it off. On a general loan, whether it be interest-only or principal-and-interest, you are charged interest generally on a monthly rate that you need to pay.
Let’s say we have a property that is $100,000 and, for a argument’s sake, let’s say it’s 6% per annum; which is 0.5% per month. So we have $100,000 and 0.5% interest per month is charged to us – which is $500. So $500 per month is charged to us. On a general loan, we would pay that $500 per month to the bank or to the lender that we have that mortgage with – that’s an interest-only loan. With a principal-and-interest loan, we would pay that $500 plus we’d pay a bit more to lower our debt down. With interest capitalisation, you don’t pay that money at all, it gets added on to that loan. So, we start with a $100,000 loan, let’s say it’s 6% interest or 0.5% per month.
What happens after the first month, rather than paying the $500, it’s added on to our loan and our loan becomes $100,500. The next month, we’re charged 0.5% on the new amount of $100,500 and that is then added on to the loan. So our loan would be somewhere around $101,000, a little bit more because of accumulative interest or compound interest. So, basically, over time, your loan is getting larger as interest is added on to the loan.
Now, when it comes to interest capitalisation, generally, it is for a particular period of time – might be 6 months, 12 months, 2 years. And what generally happens is that the amount is calculated so you know, at the end of 12 months or 2 years, exactly what your loan amount is going to be. And what is the purpose of interest capitalisation? Well, I guess, the benefit is that it improves your cash flow because you don’t need to pay the interest on the property so you can then use that cash for something else. But you’ve obviously got compound working in your interest.
So what’s an application of interest capitalisation? Well, applications tends to be in the construction industry. So, if you got a construction project that’s going for 12 months or 2 years, you might not have the cash in order to pay the interest repayments for that 12 months because your putting all your cash into the construction of that project, which you’re hoping to make a profit of at the end. So, what you do is you capitalise the interest over the period of the project. And then, when the project’s complete and you can sell your properties, you can use the profit for those properties to pay for all of that capitalised interest and hopefully continue to make a profit.
Capitalised interest is also often used in bridging finance. So if you’re selling a property and buying a property at the same time, but you’re buying the property first so you haven’t quite got the money from the property that you’re selling or have sold. The you may need to apply for bridging finance in order to buy the property.
This is finance that’s given to you in the expectation that a property is going to sell and it’s going to be short-term finance. Occasionally, people will capitalise this because they’re already paying interest on the property they’re trying to sell and they may not be able to afford to pay interest on the bridging loan as well, so they capitalise that interest. And then what happens when they sell their property, they then convert that loan into a standard loan.
So they tend to be the 2 main uses of the property. The reason I actually created this post was I got an email from a guy called Frank, who contacted me – I think it was through Youtube – and he said:
“Hi Ryan, love your videos. I keep eagerly awaiting for the latest one. I was viewing your 21 Property Investment Strategies and noticed that it does not include interest capitalisation strategy. I stumbled across an ad for a company using this strategy and would like to know if you think there’s any merit to it. This company is Canterbury Property Services, I noticed their ad on realestate.com.au. The idea seems too good to be true and there are mixed opinions across various forums. Would really appreciate your thoughts on this.”
So he was watching my video on the 21 Property Investing Strategies, which you can check out at onproperty.com.au/236, if you’re interested in that. But he wants to know about this interest capitalisation strategy. And truthfully, this was the first that I’ve heard of it. There’s not a lot of people talking about this. There’s not a lot of people using this. It’s seems to be Canterbury Property Services’ kind of their way of getting clients and differentiating themselves in the marketplace. They create this strategy called Interest Capitalisation to help you pay off your non-deductible home loan faster.
So, basically, from watching videos – they had an animation video that talked about their service. What they do is you take your home loan – so you need a home loan to start with in order to use this interest capitalisation strategy. And I’ll talk a bit more about why you need a home loan in order to do that. But, basically, what you’re doing is using your existing home and the value in that to get 100% loan on a new property.
Generally, I think it’s a new-build property because they’re making their money through commissions. And you guys know how I feel about property advisors and how they’re making money on commissions of new-build properties. To mitigate against that risk, go to onproperty.com.au/282 to see the 7 Things You Should Do Before Buying Through Any Property Advisor, including Canterbury Property Services.
Basically, what I could understand from what they’re doing is that you have a home loan and what you do is you get an equity loan on that and you then get another loan on the property. So, you basically got an investment property with 100% loan-to-value ratio. You then capitalise the interest on that property for either 1-2 years.
What that means is the biggest expense on that property or the mortgage, you don’t have to pay because it’s being added on to the loan. It’s still an expense, you’re just not paying it. So, what that means is rather than paying the interest on that property, you’re actually taking the money you would have paid to pay off the interest on that property and you pay it off on your home loan – with the goal being that you increase your tax-deductible debt while reducing your non-tax-deductible debt.
Now, you definitely need to go and see an accountant about this capitalisation of interest and whether that increase in value of your loan you can then claim against that increase in debt as tax-deductible debt. So, that’s very confusing, alright? Let me try and explain it.
So let’s say you’ve got – let’s just use super basic example. Alright, you’ve got $100,000 home loan. Now, you can’t claim that as a tax deduction in the interest you pay on that because it’s your home, it’s not an investment. If you then have $100,000 investment property loan, you can then claim whatever interest you’re paying generally becomes a tax deduction, which you can claim against the income of that property as well as your own income.
But if you were to capitalise that interest – let’s say we had 6% over the course of 12 months that we capitalise – your loan on your investment property would increase from $100,000 to $106,000, so your loan has increased. But what I’m not sure of is – is that $6,000 increase in loan, the interest that you pay on that when you stop capitalising is that tax-deductible?
So you can pay off your home loan a bit but I don’t know if you’re actually increasing your tax-deductible debt. It’s very funky, it’s very strange what they’re doing because, obviously, they’re encouraging you to pay down your home loan, but I just don’t know if increasing your tax-deductible debt is so valuable that you actually capitalise interest on a property. And from what I read in the forums, they tend to be marketing negatively-geared properties, new-build properties with high depreciation and it seems like they want that high depreciation because they’re selling new-build properties.
Now, I’ve talked about property advisors and how they make money. But generally, they make the bulk of their commission through the building contract and they also partner a mortgage service in that so that they can structure their finance to more easily get the loans for the property if the property is overpriced and kind of keep you in the dark about that. So, it’s a very, very grey area of the industry, people who do that. I hate it because it’s not very transparent and it leads to people buying overpriced properties.
I think the concept of capitalising interest – it’s interesting and I think if you’re a very sophisticated investor, you really understand your numbers, then it could be good for you. If you’re going to someone like Canterbury Property Services and you’re getting them to do it, that means you don’t really understand it. Because, truthfully, I don’t really understand it and I have a good grasp of this sort of thing. If you’re going to them, it means they’re telling you about it, you don’t really understand it.
You only know what they want you to know. And that means that it’s going to be very hard for you to monitor and to not let it get out of control and for you to take advantage of it.
So, I think for the standard investor, it’s probably a risky strategy. Just because of that lack of understanding of what’s happening there. The benefits of capitalisation is that it improves your cash flow because you’re not paying the interest, you’re adding it to the loan. And then, when the growth of the property exceeds the interest that’s being added to the loan, well then, you’ve got effective profit or equity growth in that.
There are some negatives, though, that you need to be aware of. You will end up with a higher loan value and higher interest rate repayments after capitalisation. And capitalisation is generally for a short period of time – 12 months to 2 years. So, you will end up with a larger loan with large interest repayments. So, even though it might benefit you for 12 months to 2 years, at the end of that, you’re going to be in a worse cash flow position because you’ve got a higher loan. You’ve got compound interest working against you, which is a negative. It’s an unsustainable thing to do for the long term, because you’ve got compound interest working against you, so your loan gets higher and higher and higher and higher.
Eventually, what’s going to happen, which is a negative, is that your loan-to-value ratios will get all out of whack. Because your interest is going up, if the property’s not going up as much, eventually, your loan’s going to exceed the value of your property and the bank’s then going to say, well, we’re not going to capitalise your interest any more.
You need to pay it. You’re also not going to be able to borrow any more money. So, it could severely affect your borrowing capacity. But, obviously, talk to a mortgage broker about that, I’m not 100% sure.
Capitalised loans generally have higher interest rates as well. I know that’s true for bridging finance, not 100% sure about construction finance or standard finance. But, yeah, they’ll be hard to get, higher interest rates and then there’s that question about is the increase in loan actually tax-deductible? So if your goal is to invest in property to pay off you home loan faster and to generate passive income, absolutely. That is an awesome idea. But doing funky finance to invest in negative-geared property to pay off your home loan faster but increase the loan on your negatively-geared property, making it more negatively-geared – using that as a way to generate passive income and achieve financial freedom just doesn’t make sense.
In the long term, you’re going to end up with a bunch of properties that are severely negatively-geared and as soon as your interest capitalisation runs out, you’re then going to need to pay those negative-geared properties and you’re not going to be in a passive income situation at all. And so, really, you’re just relying on capital growth of those properties – which you could do using any strategy.
So, the idea that capitalising interest to pay off your home loan and achieve passive income and financial freedom faster is just another way to sell you and to confuse the heck out of you. So, do I think it’s good? If you’re super sophisticated, I think it could be a powerful tool. Interest rates are low, 5%, if you can make more than what your paying in interest over the course of that 12 months to 2 years, then, definitely, a potential for a profit-generating process. But if you don’t understand it and you’re using it to try and generate passive income, just doesn’t make sense to me – or maybe I’m wrong.
Leave your comments in the section below if you think there’s something that I’m missing here. But, for me, if I want to go ahead and generate passive income and financial freedom through property, why would I go through a company like Canterbury Property Services or anyone else who’s going to charge me commissions on the new-build property which will likely lead to overpriced property. Why would I go through them when I could either hire a buyer’s agent to find me an existing property or I could go out and I could do the research myself, find a property to invest in – whether that be for positive cash flow or for capital growth.
Why wouldn’t I just buy an existing property and just do all of this using the standard finance, which is going to likely be easier to get to increase my borrowing capacity because I don’t have weird capitalising loans. It just sounds too complicated for me. It just sounds very hazy. It sounds like a tactic and I would be very, very worried about working with someone doing interest capitalisation.
Guys, I hope that makes sense. As you can see, I don’t really understand it completely why it’s a good strategy. If they can convince you otherwise, I wish you the best of luck. But I would definitely have my red flag up and say this is probably some sort of scheme to get more sales. And I would definitely, definitely, definitely, if you’re going to buy through these guys or through anyone else, please go ahead and check out my 7-point checklist on things that you should do before purchasing property through a property advisor. Go to onproperty.com.au/282 to get access to that.
This is just going to allow you to do some research to understand, is this property overpriced? What am I actually getting? And actually mitigate your risk on that property so you know you’re buying a good property in a good area that isn’t overpriced. onproperty.com.au/282 – get access to that, it’s absolutely free.
Alright guys, until next time, stay positive.