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.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
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.
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.