26 Giffard Street
Williamstown 3016
Ph. 03 9397 7275
Fax. 03 9397 1734
Mobile. 0428 310 165
Email. reidcont@tpg.com.au
ABN: 65 111 801 079
www.reidconsultants.com.au

This newsletter continues a theme of some of the earlier concepts I have written about, Wealth Creation (April & May ’06), Wealth Creation through Property Investment (May ’07) and Rent vs Buy (April ’07). In this newsletter we compare the financial aspects of buying your own home first against buying an investment property first while continuing to rent. The end goal is long term wealth creation.

There is clearly a choice available to many first time property buyers who want to enter into the property market, buy your own home first and then look at investing in property further down the track OR buy an investment property first while continuing to rent.

Which path is right for you will depend on your circumstances, your lifestyle and your long term goals. Both provide a vehicle to create long term wealth, where debt is used (other people’s money) to purchase long term capital growth assets. Our April ’07 newsletter ‘Rent vs Buy’ has a discussion on the advantages of either alternative. There are substantially different financial outcomes between the two and serious consideration needs to be given to these for a first time property buyer.

One of the main issues for many 20 year olds who have entered the workforce and are considering their financial future, indeed their future lifestyle, is that they do not want to be locked into having to service debt for 30 years or longer. To buy a car, take a year off and travel, live in different parts of the nation or world or wanting flexibility if a job transfer opportunity occurs are all worthy goals.

Creating wealth is not only about sacrifice, it is about creating a balance between lifestyle and financial freedom, both now and in the future. Structured correctly, an investment decision to create long term wealth should not lock you in to self sacrifice for the next 30 years, nor should it limit you to being able to make those decisions in the future. However it is not about being able to do it all immediately either. There is a period where you may need to save, to limit your lifestyle while waiting for your investments to grow to a stage where you can relax and have choice.

I will use an example of a single 22 year old, Jane, living at home, paying board (she could easily be renting independently), salary $33k pa, with no other debt. Her net income is shown in the table on the right. Jane has made a smart decision and is paying after tax dollars into her superfund, as her income level is less than $58k pa, she is getting the benefit of the government co-contribution as well. In this case her board is $50 a week, but it could be a $100 a week shared rent or more. She is left with a disposable income of $468 per week to pay her bills, run her car and general lifestyle and savings.

If Jane decides to purchase her own home, her ability to borrow is around $250k for a property, slightly more for some lenders, slightly less for others. If we use $250k as a purchase price and Jane has $25k saved or access to that amount, perhaps family pledge or parent support, Jane may be able to buy a small flat in a reasonable location. There are significant additional costs when buying property, around $11k for stamp duty and land transfer registration in this case. There may be loan application fees depending on the lender, up to $1k. As Jane only has a small deposit, she will need to pay Lenders Mortgage Insurance (LMI – which is solely to benefit the lender), for this example, around $5.3k. Jane will need to borrow $242k, being a 97% Loan to Value Ratio (LVR). I will ignore the effects of the First Home Owners Grant as it normally used to form part of the deposit, rather than affecting the ongoing financial viability

The purchase price is $250k, with a deposit of $25k.A loan term of 30 years on a P&I loan.Interest rate is 7.65% Her repayments for a Principle and Interest loan (P&I – where both interest and principle is paid off over time), Jane will be paying about $1,717 a month, or $396 a week, together with the other expenses involved in owing a property. As you can see from the table, her disposable income of $87 per week leaves very little to have a lifestyle at all.

This is the crux of the issue of home buyer’s affordability, for Jane on a relatively low wage as she is just starting out in the workforce, the percentage she would need to pay out of her income is 62%. The general guideline used by most banks is that 30% is the percentage of gross income that they are comfortable with. That means Jane would need a gross income of $69k per annum

The above is from The Australian, illustrating the difficulty facing new home buyers

What if Jane takes another approach and decides to continue boarding with her parents (or renting) and buys an investment property. We will use the same scenario as above, with a gross rental received of $200 a week, not unreasonable for a good location (a yield of 4.2% gross).

The advantage of purchasing an investment property is that you have a tenant helping pay your mortgage. You need to get the strategy right, buy the right type of property in the right areas and borrow to your limit using other people’s money to increase your return. If it is a negatively geared property, meaning the outgoings or expenses are greater than the rental income, you can claim the difference against your other income and then the taxman helps pay off your mortgage as well. If it is a positively geared property, your tenant is paying your mortgage for you and more.

The purchase price is $250k, with a deposit of $25k.A loan term of 30 years on an Interest Only loan.Interest rate is 7.65% Her repayments for an Interest Only loan (IO – where only interest is paid off over time), Jane will be paying about $1,542 a month, or $355 a week. There are additional expenses to pay. As you can see from the table, the end result is significantly different from paying off your own home. The tenant pays rent, the tax man gives you tax relief (in this scenario, nearly $3k pa) and Jane now has a disposable income of $335 per week.

While Jane’s disposable income is lower than before (down from $468 a week to $335 a week), she still has a reasonable disposable income and an asset that appreciates in value. If the property value only grows at 5% per year, five years time, it will be worth $318k, the loan remains at $242k, her equity or net worth has increased by $52k (319-242-25 (deposit)). If Jane has chosen well sand the property value grows at 10% pa, her equity will have increased by $135k.

This does not happen by itself, you need to get the basics right. You need to claim the income tax variation so the tax you pay on your weekly (fortnightly/monthly) wages is amended to reflect the negatively geared position, you need to have depreciation schedules prepared, you need to structure your finances correctly and obtain the right loan product. Get a team around you that understand what your goals are and who are also active property investors in their own right. They can give the appropriate advice, rather than a bank clerk, mortgage broker or accountant who may know their product or tax rulings, but not know what can be achieved to your benefit.

The question you need to ask yourself, how else are you able to do to generate this type of wealth over time? Once Jane has built some equity in her investment property, she then has the ability to purchase another property and use more sophisticated finance strategies that will not greatly affect her disposable income or compromise her lifestyle.

Give me a call to find out whether this strategy would work for you and what could you borrow based on available cash flow and deposit. We can help set up a team around you of experienced professionals. We take the approach of looking at your long term goals and working to find a solution through finance for you. This appointment is no-cost and is obligation free, call – 03 9397 7275

Helping People through Finance