We’re back with crucial information about Negative Gearing. If you’ve been following us we recently released a very introductory article about what it means to enter into a negative gearing investment. If not you can head on over to Negative Gearing: What is it & How Does it Work? be sure to have a quick read. In this part of the mini-series we are going to touch on potential risks associated, as you should know by now every investment does carry a degree of risk.
First and foremost sound knowledge of ANY investment would be to borrow well within your means. Although negative gearing increases your overall potential property investment gain, it also increases your potential loss. High Risk = High Reward but don’t forget that High Risk = High Loss Potential.
It’s important to understand that once you decide to enter into negative gearing your property, you still record at a loss and if you’ve ever heard the saying “a loss is a loss is a loss” well you’ve heard it now. There’s no other way to put it.
Seeing as you’re obligated to pay your debts back and there’s no such thing as free money there are some things you need to ask yourself. We will give a basic scenario and a fitting question to help you out.
Your loan facilitator has just released a statement stating a spike in interest rates within the next 12 months.
Q. Do you have enough liquidity (cash) to cover the difference between the low rental payments and the new loan repayments as interest rates have risen?
Rental agreements differ from state to state but typically have a clause stating that you can’t increase rent given specific circumstances. Therefore, as interest rates increase your rental income will stay the same not correlating with the new loan repayments.
Your prospective investment property is in a prime beachfront location so you take out a higher amount of money as you feel you will always have tenants.
Q. What happens if during the winter months you have difficulty filling your rental property?
Just because you can’t find tenants for your property it doesn’t mean you won’t have to make repayments on your loan. It’s important that you take into account that some months it may be more difficult to find tenants, and rental income acquired may be severely reduced or to none at all. You will have to ask yourself if you have enough wiggle room to offset any lack of rental income.
Property values in your area have drastically decreased and a ‘housing bubble’ is looming ahead. You now realise that your investment property was overvalued.
Q. Will you be able to handle the fact that your investment property fails to increase in value and significantly decreases to below your purchasing price? Can you financially, emotionally, and economically afford to sell your investment property at a loss?
You have been in a stable job and receive a competitive salary income, but unfortunately you are affected by unforeseen changes in your income.
Q. Will you be able to handle the shortfalls or potential cost blow-out from your reduced income? Seeing as alot of things in life aren’t 100% guaranteed, negative gearing can be potentially disastrous for low/moderate income earners. You will have to be sure you can handle shortfalls and be financially capable.
As you can see, with any investment you need to be sure you can handle any negative drawbacks or losses. These simple scenarios and questions should help you to do your due diligence. How would you handle the above scenarios and questions if they came to fruition? Losses of income are the Number 1 threat of negative gearing and it shouldn’t be taken lightly. Of course, with any risks taken in life there is always a way to mitigate, offset, or minimise and that holds true with negative gearing.
Next week we will release a post about ways to minimise risks associated with negative gearing, so stay tuned!