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With the cost of housing at record high levels people are
borrowing significantly more than they have in the past to purchase a home. This was
not a significant issue when interest rates were at record
lows, however, as we are now in the midst of a rising interest
rate cycle and the effects of the United States sub-prime lending crisis
are flowing into our credit markets, the pressure is
starting to be felt among some home owners.
This increased
pressure has encouraged home owners to think creatively about how
they can reduce their massive mortgages so they don't have to be
paying them off for the next 30 years.
I love creative thinking but I dislike the fact that most
of the ideas I hear involve more debt. Using debt to solve
your debt problems is like throwing petrol on a bush fire. Debt
is not creative - it's a burden.
The
borrower is servant to the lender.
Most of
the "creative" ideas that home owners think of as a way out of
the mortgage "black hole" involve using the remaining equity in
their home to invest in another asset that will increase at a greater
rate than their mortgage interest rate of around 8%.
This is where
the logic comes unstuck. Such strategies do not factor in:
1. Tax on the
investment earnings
2. Capital gains tax on the sale of the
investment
3. Entry and exit
costs (stamp duty, legal and selling costs)
4. Increased cash flow
requirements (because in most cases the interest expense is greater
than the revenue earned
5. Level of risk involved
Example - Equity
to invest in property
Let's assume
you own a home with a current market value of $650,000 and you have
a mortgage of $300,000 at an interest rate of 8% with 25 years of
the 30 year term remaining. This means you own about 54% of your
home or another way of looking at it is you have $350,000 of
equity. Banks allow you to borrow against the $350,000 of equity in
your home to invest in another asset.
Let's say you
buy an investment property worth $334,000. You will pay about
$16,000 in stamp duty so you now have debt of $650,000 and assets
worth $984,000. Your equity has already reduced from $350,000 to
$334,000 due to the stamp duty you had to pay.
Although the long term average increase in residential property is generally in line
with inflation (currently around 3.5%) let's assume that the capital value
of the property increases at 10% p.a. and you
sell the property 5 years later. The investment property would be worth
about $538,000.
Assuming the property is tenanted
100% of the 5 years you own the property you will have received
about $48,000 in rent, paid $140,000 in interest payments and
needed to chip in additional cash of $92,000 or a little more
than $18,000 p.a. After factoring in tax savings at a 40% marginal
tax rate this amount would effectively be about $54,000 or nearly
$11,000 p.a.
If you sell the property for
$538,000 you will pay about $11,000 in legal and selling costs
and capital gains tax of $37,000. Overall you come out with a
net result of approximately $86,000.
Applying the
$86,000 to your mortgage at that point in time would more
than halve the 25 year term of the loan and save
you around $190,000 in interest payments on your mortgage. Sound like a
great idea? Well think again.
You could
achieve the same result and take no risk by applying the additional
cash flow required to support the investment property (around $11,000 p.a.) to your
mortgage for five years. Taking this approach avoids the risk of the
property not being tenanted, the property not increasing sufficiently in value, stamp
duty, legal and selling costs.
Don't risk your
family home by going into more debt in order to get ahead. Be
creative in generating additional income, diligently make additional
payments on your mortgage and become debt free. You'll
stamp out debt related stress, free up cash flow to accelerate
wealth generation and be a lot happier.
Back
This
newsletter does not take into account the personal objectives,
financial situation or needs of any person. You should consider the
appropriateness of the information having regard to your own
objectives, financial situation and needs and obtain professional
financial advice prior to making any decision.
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