What your lender really thinks about negative gearing
In investment terms, gearing means borrowing. So when you engage in negative gearing, the borrowing expenses for the house or property you purchase with the loan exceed the income earned from the property.
For example, if you borrow to purchase an investment unit and receive $10,000 rent per annum but your costs, such as interest, agent’s fees and rates amount to $17,000, you’re losing $7,000 per year. The Tax Act allows you deduct this $7,000 loss from your wage or salary. So, if you’re currently receiving $50,000 a year in salary, you now pay tax on $43,000 ($50,000 minus $7,000).
The strategy is only to make a loss in the short-term. In the long run, the value of the property that you hold for say, 10 years, can rise significantly and deliver you a large capital gain, especially if you buy in an area that becomes the next hot spot. In the short-term, you’re still losing on the property, but you are betting that the capital gain on the house or unit outweighs the loss and the eventual capital gains tax you pay.
So how do lender’s view negative gearing?
When considering this question, it is critical to recognise that first and foremost, lenders are required to prove that their applicant can afford to meet the repayments of any loan they are providing. This is done by calculating the applicant’s after tax income and deducting their living expenses and the payments on any other loans, credit cards, etc. After this calculation is complete, the applicant must have sufficient remaining cash to meet the proposed loan repayment.
How does negative gearing meet this requirement then, if it adversely impacts an applicant’s taxable income (at least in the short term)? To account for the strategy, a lender will make adjustments to their income and expense calculations for a borrower seeking funding for an investment property. They do this by adding the rental payments from the property to the applicant’s income and by making allowances for the tax deductibility of the interest expense. They will, of course, also allow for the added expense of the loan repayment.
Simple really! But following the pressure from the banking regulator APRA, lenders are taking a more conservative stance in respect to investment lending and the tax benefits of gearing. This has resulted in changes to the way lenders view the following aspects of the income/expense calculations for investors. In particular, 3 main factors have been impacted:
• Rental Income Assessment
Lenders now discount the rental income from investment properties in their calculations.
That is, they reduce the amount of rental income they will use for their assessment. For example, many lenders discount the rental income by 20%. So if an applicant receives rental income of $20,000 per annum from their investment property, and the lender discounts that amount by 20%, the lender is only including $16,000 of the rental income. If the applicant has several rental properties and each is subject to the same treatment, this can reduce the income in the eyes of the lender by tens of thousands of dollars.
• Tax benefits of interest cost
Under our tax legislation, the interest expense attributable to investment property loans is tax deductible. Although allowable, lenders are now very cautious in using this tax allowance when calculating an applicant’s after tax income, i.e. the cash they have left to pay their loans. If an applicant is relying on a negative gearing benefit to prove their capacity to meet the proposed loan repayments, lenders will have a heightened level of caution and scrutinise the loan more closely, as it is considered a higher risk. Some lenders even exclude this allowance altogether.
• Assessment of existing loan repayments
When assessing a residential loan application, lenders add a loading or stress margin onto the interest rate of the loan they are considering. For example, the interest rate most lenders apply to assessment of the new loan is currently in the region of 7.5%, not the 4 -5% the applicant is actually going to pay. Why do they do this? In simple terms, it is to allow for the negative impact on the applicants expenses due to the inevitable rate peaks and troughs through different economic cycles. It is prudent lending to minimise the risk to both the borrower and the lender. Whilst many lenders previously used this practice, the loading that they now apply has increased significantly. To give you an example of how this can impact an applicant’s repayment capacity calculation, I recently reviewed a request where the applicant was paying $1,800 per month on an existing loan. After the lender applied their interest rate loading, the figure they used was almost $3,200 per month. This simple policy rule had added over $14,000 to the applicant’s annual expenses for the loan assessment.
When all of these factors are applied to the calculation of an applicant’s capacity to make their loan repayments, the disparity between actual current income and expenses can be immense and the more investment properties and investment loans they hold, the bigger the difference becomes. When a property (or properties) is negatively geared, this gap is magnified and is often the reason for an investment loan application being declined.
So how do lenders view negative gearing? The answer is that they make allowances for the taxation benefits of negative gearing, but their risk preferences and their policy settings are biased against negatively geared and towards positively geared investors.