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When to buy that first investment property

May 7, 2015

You’re diligently paying down the mortgage on your home and perhaps using record low mortgage rates to make additional payments. You’ve made some headway in getting the debt down and it no longer feels the boss of you. A return to debt-free living is a prospect rather than a dream.

But some of your acquaintances have an investment property and you may be wondering if your laser-like focus on shrinking the home mortgage is really the best path.

You may be right to be reassessing your priorities.  Whilst owning your own home debt-free is usually a necessary condition for financial security in our later years, it generally isn’t a sufficient one.  It will of course allow you to live rent free in retirement but it won’t supply the funds for living and enjoying life.

Financial security comes from building assets beyond the home, generally across shares and property, inside and outside of super.

There is no one-size fits all rule of thumb about when to expand horizons beyond the home mortgage.  But the answer usually revolves around four factors: the amount of equity in your home, your surplus cash flow, the cost of servicing your home mortgage and the imputed rent of your property.

Some definitions. Equity is of course the difference between the value of your home and the remaining associated debt.  And imputed rent is the amount a homeowner would have to spend if they were a tenant in their home rather than a mortgage-paying owner.

Equity builds both through paying down debt and through a rising asset value. Lenders view a borrower as a low risk once they have 20% equity in their home.  They know that this is a buffer against most market corrections and hence why one doesn’t need to pay lenders’ mortgage insurance beyond this threshold. Reach a good stash of equity – say 40 to 50% of the home’s value – and the bank manager is then bending over backwards to lend you money to finance an investment property.  The additional borrowings will of course reduce the equity percentage (now measured across the home and prospective investment property’s purchase price) but you’ll likely be allowed to keep borrowing until the total equity across your home and prospective investment property doesn’t fall below 20%.

A simple example to illustrate: you have a $1m dollar home with $700,000 in debt – that’s $300,000 (or 30%) in equity. The bank may well lend you another $500,000 to invest in a good apartment and you’ll still have 20% across the two assets (if we ignore transaction costs).

The next factor is whether you have sufficient spare cash flow to fund the investment. That’s a straight forward pen-and-paper budgeting exercise, although one should stress test the outcomes by using a mortgage interest rate two per cent higher than today’s level.

Finally, it is a case of deciding whether you’re better off putting these additional funds into funding an investment property or paying off the home’s mortgage. When one buys that first home and are mortgaged to the hilt, the interest payments are very high, generally much higher than it would have cost to rent the same property. It’s wise to reduce the size of the principal to a point where interest payments costs are around the same as the imputed rent.  Once this milestone has been reached, consider changing your mindset. In essence, evaluate the relative return on investing in reducing your home mortgage versus putting surplus cash flow into an investment property.

Typically, because an investment property selection process is unencumbered by lifestyle matters, one is generally able to find an asset with a better rate of return than the family home. The case for investing is also invariably sweetened by the tax benefits such as negative gearing.

Next steps: Talk to Wakelin Property Advisory about selecting a property that will perform as a property investment. Click here to read the process we undertake.