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How Does Positive Gearing work?
Are you considering investing in property and want to know more about what positive gearing means?
Here is a quick guide to how positive gearing works, including the potential benefits and what to watch out for.
What is positive gearing?
Put simply, a positively geared property (also known as a ‘cash flow property’) is an investment that generates more in rental income than it costs in loan repayments, strata fees and other expenses associated with ownership.
You may end up with a positively geared property if you’re able to put down a large deposit, reducing the amount you need to borrow and lowering your interest charges, or if you purchase a property during a time of strong rental demand and low interest rates.
What should I know about positive gearing?
As with any investment, it’s important to weigh up the possible advantages and disadvantages of owning a positively geared property.
Some of the potential benefits of positive gearing include:
- Passive income. A positively geared property can provide you with a steady income stream as well as future capital gains if the property increases in value over time.
- Less cash flow risk. Because a positively geared property pays for itself, you don’t need to use other income to make your mortgage payments or have to consider selling under pressure if your financial circumstances change.
- Easier lending. With additional positive cash flow boosting your income, it can be easier to secure a loan.
However, there are a few things you may need to account for, such as:
- The income is taxable. Just like the wages you receive from your job, you must pay taxes on any income your property generates.
- The higher cost. The more upfront capital you have to purchase your investment property, the smaller your mortgage is likely to be, which will make it easier to make a profit on rental income.
- The property can be more volatile. It may be easier to positively gear a property that is cheaper to purchase. As cheaper properties are often located in areas that may not experience the same property value growth as other, more expensive areas, it’s possible the value of your investment may be hard to predict.
To give you an example of how positive gearing may work in an investor’s favour, let’s say you decide to purchase a property for $650,000 located in a regional area, where vacancy rates are low and rental yields are high.
You put down a deposit of $300,000 and take out $350,000, 30-year home loan, with the interest rate fixed at 3.75% for the first three years.
The interest on your mortgage is $13,000 for the first year and you spend an additional $7,200 on other property-related expenses. That’s a total of $20,200 in expenses for the first year. However, due to strong rental demand in the area, you’re able to charge $1,000 a week, making an annual rental income of $52,000.
By deducting the total expenses from the rental income, you can see that your property is positively geared in the amount of $31,800.
While this amount counts as taxable income, there is a range of special deductions you can make as an investor to reduce your tax burden.
As always, it’s important to take into account your personal situation and any tax implications before buying an investment property. Be sure to consult with your financial adviser to work out the right investment plan for your individual circumstances.
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