In the current market, with interest rates rising rapidly, many investors find themselves experiencing precarious cash flows, as bond repayments have escalated dramatically over the last two years. Is refinancing the answer to the widening cash flow problem?
The short answer is: yes – if you have done your homework and if you are disciplined enough to follow the rules. If you do not have the time or the inclination to do the homework and lack the discipline to follow the rules, you may be well advised to find another solution to your cash flow constraints.
The underlying principle
When you initially finance a property, the bond can be registered to a maximum of 100% or 108% of the purchase price. The purchase price may and should already be less than the market value if you found a good buy or negotiated well in your purchase.
The value of the property increases every year, and during the recent property boom, the value of many properties increased by as much as 30% in one year. There are various ways – apart from normal capital appreciation – in which an investor can increase the value of a property; for example, by renovating the property, adding extra rooms, or simply painting the walls.
The bond amount, however, remains the same, and each year the difference between the bond amount and the current market value of the property increases. This difference is called equity.
Refinancing is one way of turning this equity into cash, which investors can use for various purposes. In essence, the bond amount is increased to a value that is closer to, but usually will not exceed, the current market value of the property at the time the refinance is applied for.
This is one of the most powerful tools investors have at their disposal to maximise gearing and leveraging. It is an investors’ tool that involves adherence to a fundamental property investment success secret: using other people’s money to build their portfolios.
Accessing equity: refinancing vs selling
Another way in which investors can access the equity in a property is to sell the property at the current market value and pay off the outstanding bond amount. This method, while often used, is a rather inefficient method of accessing equity in a property.
Firstly, you will no longer own this property, and smart investors know that property should only be sold in exceptional circumstances.
‘You may reason that if you sell your R1 million property, which has a bond of R500 000, you will have R500 000, bond-free, to invest in another property. But why sell the property to access the equity, if you can refinance to access the R500 000 equity?’ – ‘If you refinance, you will still have access to the R500 000 to invest in another property, but you will not lose the first property. Now you will own two properties instead of one.’
There are other reasons why selling is not the most efficient way of accessing equity. Firstly, you will never again be able to buy the property you are selling at the price you paid for it. The longer you keep the property, the greater the return on your investment. Unless there are exceptional circumstances, never sell property you own.
Secondly, there are costs involved in selling a property. You will have to pay an estate agent up to 7% to sell the property for you. You could sell the property yourself, but even then, there will be advertising and administrative costs involved.
Thirdly, since this property is likely to be a second property and not your primary residence, the capital gains you make on the sale of the property will be subject to capital gains tax, without the rebate that applies to a primary residence. This could take a sizeable chunk out of your profit.
And lastly, there are bond cancellation costs and attorneys’ fees that you will have to pay when you cancel the bond due to selling the property.
Here are some of the reasons why you might refinance a property:
- Obtaining a better interest rate on the existing bond amount through another bank. This is called ‘switching’ and can reduce your monthly repayments. Saving on the interest rate you pay the bank has the same net effect as earning interest.
- Refinancing is also used to restructure the finance – for example – taking the bond over a longer term or fixing the interest rate. This will ease cash flow constraints and provide some protection against interest rate hikes.
- Accessing the equity in the property.
- Taking advantage of new bond products that will offer you a better deal than your current bond.
Why access the equity?
The equity can be used for various reasons, and some reasons, such as the following ones, are much smarter than others:
- Consolidating your debt by settling high-interest, short-term debt to boost your monthly cash flow and save on the exorbitant interest rates on short-term debts, such as credit cards and store accounts. This means that you will be paying off a higher amount on your bond, but at a much lower rate than the short-term debt attracts. The difference between the total repayments on your various short-term debts and the increased bond repayment can represent a significant monthly saving and will ease your monthly cash flow constraints.
- Obtaining cash for a wedding or for a university education. Funding a business or buying shares.
- Obtaining cash to invest in another property.
- Renovating a property.
- Creating a back-up reserve of funds to cover the shortfall between the rental income and the bond repayments on the property or properties.
In terms of property investment, refinancing allows investors to gear their equity to buy another property, or to renovate a property to increase its market value or improve its potential rental income.
The equity can also be used to create what is called a ‘war chest’ – a backup reserve of funds that investors have access to for covering the shortfall between the rental income and bond repayments, which have increased dramatically over the last two years. This ‘war chest’ will also provide access to cash for those unexpected repairs, levies and maintenance on a property that could prove devastating when one’s cash flow is tight.
There are risks involved
As with all investment strategies, there are risks involved in refinancing. You have to consider the impact of the increased bond repayments on your cash flow, especially if it is already constrained.
Remember that, if you use the equity for whatever reason, it will be depleted at some stage, but the increased bond repayments will impact on your cash flow for many years, until your bond is paid off. If you are using the equity to ease shortterm cash flow constraints, remember that this extra cash will not last forever and, when it is depleted, your cash flow may be even more constrained by the higher bond repayments.
Another substanial risk is that interest rates may go up, increasing the higher bond repayments even further and leaving you potentially exposed. If this happens before enough time has passed for the property to increase in value, you may not be able to refinance again to ease your now even greater cash flow problems.
There are also the costs of refinancing and the long-term impact on your cash flow and return on investment, which must be considered.
A very real, but often underestimated risk arises from what is called the ‘wealth effect’. After a period of careful budgeting and juggling to make the cash flow positive for a property, the sudden relief of having R500 000 as a safety net often creates a false sense of security. This may result in investors succumbing to the temptation to use the equity to cover day-to-day living expenses or lifestyle debt, or investors may relax their own rules in terms of their budgeting and investment strategies.
Refinancing is a tool that should be used wisely, and you have to follow the rules to avoid the pitfalls.
As we mentioned at the beginning of the article, refinancing is the right option if you have the discipline to follow the rules.
- Do your homework. You cannot refinance a property simply because, for example, the new bond has a lower interest rate. There are many variables that come into play, and you have to do the calculations.
- Never use the equity for lifestyle expenses. Having access to R500 000 may prove to be too much of a temptation if you really want a new car, or if you really deserve a holiday. This is a huge mistake. Your equity should be used solely for investment purposes. If you squander it on lifestyle expenses you will find yourself in serious trouble sooner or later.
If you follow these two rules, you can avoid the pitfalls and common mistakes that have seen many investors get into serious trouble.
The mistakes and pitfalls commonly made by investors in refinancing their properties include the following:
- Not understanding or factoring in all the costs involved. These include attorneys’ fees, bond cancellation fees and penalties.
- Not calculating the break-even point. If refinancing at a lower interest rate will save you R200 per month on bond repayments, but the cost of the refinance is R2 000, it will take 20 months to recover this cost.
- Simply refinancing with your current bank without investigating the interest rates and bond products offered by other banks.
- Not investigating the impact on your overall investment strategy. Refinancing may solve your immediate cash flow problem but create much bigger problems in the future.
- There are many variables to consider, and refinancing without expert analysis could lead to serious long-term implications.
How to refinance
There are two ways of refinancing a property, which are the following:
Option 1: You could approach your bank to increase your existing bond to reflect the current market value of the property.
Option 2: You could cancel your existing bond and refinance to reflect the current market value of your property through another bank.
Option one may take less effort and will not attract bond cancellation fees, but it may not be the best option. If your existing bond holder will not refinance the property, or if you can get a better interest rate or a better product with another bank, option two may be the way to go.
You have to do your homework and do the calculations carefully, taking all the various costs and implications into consideration. It is highly advisable to get an expert opinion from a reputable bond originator. This expertise is available to you free of charge.
Here are the steps involved in refinancing your property:
- Establish what the bond cancellation fees and penalties on your existing bond will be. Some banks do not charge a penalty fee, and some will only apply this fee if you do not give them notice of the cancellation within a certain period of time, which could be up to 90 days.
- Speak to a reputable bond originator to help you establish the costs of registering a new bond.
These will include:
- the initiation and valuation fees charged by the bank, which could vary between R1 000 and R5 000 and the bond registration costs, which you have to pay to a conveyancer to register the bond over the propertyin favour of the bank. This fee consists of stamp duty and VAT, transfer costs or conveyancing fees, and the bond costs payable to the deeds office for the registration of the bond.
- Ask your bond originator to provide you with pre-approval, to indicate what finance you will be able to obtain, and get a comparison of interest rates and product features from the various banks.
- Ask your bond originator to explain the impact of the various product features and interest rate options to you so that you can make an informed decision.
- Calculate the impact of the new bond parameters on your cash flow and on your investment strategy.
- Fill in the forms, and provide the documentation the bond originator requires to approach the various banks on your behalf.
- Consider the quotations or offers received from the various banks, taking into account the calculations you made in step 5.
- Accept the offer from the bank offering the best overall deal, and follow the process required to register the new bond.
By Monique Terrazas – Source from – http://www.reimag.co.za/2014/03/11/creative-ways-for-finance/