We save to buy a home, then work hard to pay it off… Sound familiar? Most people who own their own home tend to live for years with the extended stress of paying their principal place of residence (PPOR) through being frugal with their salary, budgeting and making sacrifices. The thought of getting into more debt may be the last thing some people want to think about. But what if owning the right investment property actually helped pay your home off faster?
The traditional method of paying down principal and interest on your home over time with savings is, well.. slow. On a median priced Sydney property of $1mil, over the first 10 years of a 30-year principal and interest loan, you would roughly pay only $15,000 a year of the principal back leaving about $650,000 on the loan to pay back over the next 20 years….
Scenario 1 – The treadmill, 30-year principal and interest loan
Scenario 2 – Using the bank’s money to get off the treadmill. Let’s look at a scenario where you purchase two investment properties around $500,000 each. If you have a reasonable income and have seen some growth in your property you could go to the bank to request to draw equity out of your home to pay the deposit and costs to purchase. This would require a new loan of approximately $250k. In the past, property in Australia has doubled in value every 7-10 years. Let’s be conservative and fast forward 10 years, if you sold both investments at this stage you would have your original equity back plus $1mil in capital gain. This would result in a net profit of just over $700,000. Just enough to pay back the remaining balance on your home loan plus a bit left over to play with…
Total investment = $1,000,000
20% deposit = $200,000
5% costs (stamp duty, solicitors etc) = $50,000
Sale price after 10 years = $2,000,000
Gross profit = Sale price – (Less purchase price ($1mil) – costs ($50k)) = $950,000
Capital gains Tax (CGT) = ($950,000/2) x 49.5% = $235,125
Nett profit = Gross profit – CGT = $714,875
So in summary you have paid your home off in 10 years rather than 30. Imagine the interest payments you would save over 20 years from Scenario 1!
So why isn’t everyone doing it? After nearly 10 years of helping clients to invest strategically and with less risk in property, I can put it down to three main concerns or fears that prevent people from taking action with the strategy outlined above; Cash-flow, performance and management of the investments.
Let’s talk about these items briefly and some of the misconceptions that create these roadblocks to financial freedom.
Cashflow- If you are earning a reasonable income, in today’s low interest rate environment buying a relatively new property at $500k with a rental yield around 5% and moderate expenses (body corporate, management fees etc), you might be surprised to find that the cash-flow after tax is actually positive. You won’t need to live on beans and rice or skip the family holiday to afford the investment property. Sound Property has some great modelling software for clients to work through with their accountant to understand how this might look for them.
Performance- As we all know, not all property is created equally, but there are basic fundamentals you can look for to ensure consistent and stable growth. At Sound Property we use our 15 Key Investment Drivers as a minimum. Stick to capital cities or economically diverse areas, away from large developments and oversupplied areas. Don’t chase fads such as mining towns and ‘cheap’ areas. For more info on cheap areas please refer to our recent post Sound News Oct 2015 where we discuss this topic in more detail.
Management- You need to remember an investment property is not your own home. It doesn’t need to be in your street so you can drive past it everyday and tend to it. It should be viewed as a commercial transaction. As such you get the best professionals to look after it. Yes, this will cost you money, but sometimes you need to spend money to make money! Insurance polices such as landlords protects you against any tenant related issues. All these running costs can be added to the cash-flow projections so there are no surprises.
With the current low interest rate environment predicted to be here to stay it may be time for you to make your equity work smarter so you don’t have to work harder. Who knows, being a bit more active with your equity may mean you can also retire earlier and get off the treadmill!
Written by Andrew Cull, Sound Property Group
To discuss this strategy with us further please contact a Client Manager at Sound Property on 1300 655 899 or firstname.lastname@example.org
This article is provided for general information only and does not constitute personal advice, as it does not take into consideration your personal circumstances. Please consult a licensed tax or financial advisor before making any decision to invest.