Interesting excerpt from a long word document sent to me some time back by a friend..
James and Susan purchased their first home in Sydney around twelve years ago, in June 1987. The home they purchased was a modest cottage, worth close to the median value for houses in Sydney at the time. In this case study, James and Susan are a fictitious couple we will use to show how, by safe and conservative planning, modest beginnings can be escalated into substantial wealth and security. They paid $83,000 to purchase the property, with a cash deposit of $21,000, part of which was used to pay stamp duty and legal costs, and a home loan from their bank of $66,000.
ORIGINAL HOME PURCHASE (TEN YEARS AGO)
Purchase Price $83,000
Purchase Costs $4,000
Total Cost $87,000
Cash deposit $21,000
Mortgage $66,000
Total Funds $87,000
Today, after living in that home for more than ten years, and in line with the actual growth in Sydney values over that period, their home has now increased in value to $220,000. They have reduced some of their home loan from $66,000 to $50,000. As it is a principal and interest loan, it has not reduced quickly. The payments on the loan in those early years have mainly been interest. Today they have equity, which is the value of the property less the amount they owe the bank, or anyone else, of $170,000.
HOME POSITION TODAY
Value $220,000
Less Mortgage $50,000
Present Equity $170,000
The actual result they have achieved in financial terms, is that equity has grown from $21,000 when they purchased the property ten years ago, to $170,000 today. An excellent result, but of course, all they own is the same home at its increased value.
GROWTH IN HOME EQUITY
Original Equity $21,000
Asset Growth (and loan reduction) $149,000
Present Equity $170,000
THE NEXT TEN YEARS
If we project their position today ten years into the future, and increase the value of their home at say 8% per annum, it will increase to $475,000. It will then be just over twenty years since they originally purchased their home, and they would have paid off the home loan. They would have equity in their home of $475,000, most of which, other than the loan of $66,000 which they paid off over the period, was achieved by natural market growth. No major renovations, or rezoning or change of land use. Just the inevitable increase in value over time. In this example we have used an 8% growth rate, rather than the historically higher 10% growth. At 10% their home would increase in ten years to $570,500, but let us remain conservative with the 8% example.
HOME EQUITY IN TEN YEARS FROM NOW
Value of Home Today $220,000
Projected Growth @ 8% per annum compound $225,000
Projected Value in Ten years From Now $475,000
Mortgage in Ten Years NIL
Projected Equity in Ten Years From Now $475,000
In ten years, with a property value of $475,000, they could sell and buy a cheaper home and bank the difference, but as their home is in the median price range, that would mean settling for significantly inferior accommodation. They may even have to rent in order to have a reasonable nest egg if they were to retire at that time.
ADDING TO GROWTH POTENTIAL
Alternatively they could do something now to add to their growth potential over the next ten years by using their property as collateral and borrowing to acquire additional property, which could be rented as an investment, with tax benefits, and most importantly, would also grow in value.
James and Susan decide on the latter plan and approach their bank manager for a loan to purchase investment property. But what are the risks? The first rule of investment is to protect existing capital. The bank would look at James and Susan’s position and should be happy to lend them up to 90% of their homes value of $220,000. At this level of borrowings they would have to pay for mortgage insurance which protects the bank’s position. But they want to remain fairly conservative, especially as a first time investment, and decide to borrow only 75% of their homes present value. Banks do not usually require mortgage insurance at this level of borrowing, as they perceive minimal risk, especially on investment in residential property.
AVOIDING BLUE SKY
If protecting our capital is our number one rule, then avoiding either "blue sky" optimism, or taking too "gung-ho" an approach to investment are important points to keep in mind.
The bank agreed to lend them 75% of the value of their home today, a $165,000 loan. But they still have a balance of $50,000, owing on their existing mortgage. If that $50,000 is deducted it leaves a borrowable amount of $115,000 which could be used as a deposit for a further investment property. The bank manager then has to establish that they can afford to service the total loan out of their income including the rent from the new investment property and the potential tax savings which would result from investment ownership. Providing those tests are met, the bank would lend them $115,000 "for any worthwhile purpose", to use a bank expression, in this case, as the deposit for another property purchase.
If James and Susan also borrow 75% of the value of the new investment property they intend to acquire, that would give them a total borrowing power of $385,000, which could be used to purchase properties worth $365,000 after allowing for acquisition costs such as stamp duty and legal fees. The next week they could go shopping for a property or properties up to $365,000 in total value.
BORROWING FOR INVESTMENT PURPOSES
Current Value of Home $220,000
Increase Borrowings to 75% of Present Value $165,000
Less Current Borrowings ($50,000)
Further Borrowings Obtainable on Existing Home $115,000
Plus Loan on New Properties at 75% of Purchase Price $270,000
Total Borrowing Power $385,000
Funds Available for Further Purchases After Purchase Costs
$365,000
You can see in the following figures with their new mortgage of $385,000 for investment property, with a value of $365,000 after allowing for stamp duty, legal fees and borrowing costs, which equate to around 5% of the purchase price of a median priced property, plus their home and existing mortgage, their total property holdings have increased to $585,000 with borrowing's of $435,000.
POSITION WITH NEW PROPERTIES
Home Investment Properties TOTAL
Value $220,000 $365,000 $585,000
Borrowings $50,000 $385,000 $435,000
Equity $170,000 ($20,000) $150,000
What they have done is increase their assets and liabilities, giving them greater exposure to future increases in values. Now they will receive capital growth on property worth $585,000.
THE FIRST FIVE YEARS
If they then do nothing for the next five years, what would their situation be? Applying the same principles and assuming values have increased at an average 8% per annum, their home would have increased to $323,000. We can assume that they have continued repayments on their home loan as they have done in the past, increasing their equity and reducing the mortgage.
POSITION IN FIVE YEARS FROM NOW
Home Investment Properties TOTAL
Value $323,000 $536,000 $859,000
Borrowings $24,000 $385,000 $409,000
Equity $299,000 $151,000 $450,000
The investment properties have increased at 8% per annum to $536,000. They still have the loan they took out to buy the properties at $385,000. If it were a principal and interest loan it would have reduced a little increasing the equity. We will assume that they borrowed interest only for investment purposes, so their total property holdings have increased to $859,000 with loans of $409,000 which is under 50% of the value of their properties. Looking at the total picture, this is a conservative level of borrowings. Their equity has increased to $450,000.
They have virtually achieved in five years what would have taken ten, if they had just continued paying off their home and left their equity passively non-productive. By putting that equity to work within fairly conservative limits, they have substantially improved their net worth. This could be achieved at relatively low ongoing cost, which is covered in detail in the next chapter. The actual ongoing cost to James and Susan works out to be less than leasing the average family car worth say $28,000 and which will fall in value, compared to owning $365,000 in additional property which will rise in value. There is no comparison - it is chalk and cheese.
After that first five year period, James and Susan are very satisfied with the results of their first property investment. They go back to the bank to show their manager what they have achieved, and seek to borrow for further investment.
This is after 5 years- Things start *snowballing* after this..
James and Susan purchased their first home in Sydney around twelve years ago, in June 1987. The home they purchased was a modest cottage, worth close to the median value for houses in Sydney at the time. In this case study, James and Susan are a fictitious couple we will use to show how, by safe and conservative planning, modest beginnings can be escalated into substantial wealth and security. They paid $83,000 to purchase the property, with a cash deposit of $21,000, part of which was used to pay stamp duty and legal costs, and a home loan from their bank of $66,000.
ORIGINAL HOME PURCHASE (TEN YEARS AGO)
Purchase Price $83,000
Purchase Costs $4,000
Total Cost $87,000
Cash deposit $21,000
Mortgage $66,000
Total Funds $87,000
Today, after living in that home for more than ten years, and in line with the actual growth in Sydney values over that period, their home has now increased in value to $220,000. They have reduced some of their home loan from $66,000 to $50,000. As it is a principal and interest loan, it has not reduced quickly. The payments on the loan in those early years have mainly been interest. Today they have equity, which is the value of the property less the amount they owe the bank, or anyone else, of $170,000.
HOME POSITION TODAY
Value $220,000
Less Mortgage $50,000
Present Equity $170,000
The actual result they have achieved in financial terms, is that equity has grown from $21,000 when they purchased the property ten years ago, to $170,000 today. An excellent result, but of course, all they own is the same home at its increased value.
GROWTH IN HOME EQUITY
Original Equity $21,000
Asset Growth (and loan reduction) $149,000
Present Equity $170,000
THE NEXT TEN YEARS
If we project their position today ten years into the future, and increase the value of their home at say 8% per annum, it will increase to $475,000. It will then be just over twenty years since they originally purchased their home, and they would have paid off the home loan. They would have equity in their home of $475,000, most of which, other than the loan of $66,000 which they paid off over the period, was achieved by natural market growth. No major renovations, or rezoning or change of land use. Just the inevitable increase in value over time. In this example we have used an 8% growth rate, rather than the historically higher 10% growth. At 10% their home would increase in ten years to $570,500, but let us remain conservative with the 8% example.
HOME EQUITY IN TEN YEARS FROM NOW
Value of Home Today $220,000
Projected Growth @ 8% per annum compound $225,000
Projected Value in Ten years From Now $475,000
Mortgage in Ten Years NIL
Projected Equity in Ten Years From Now $475,000
In ten years, with a property value of $475,000, they could sell and buy a cheaper home and bank the difference, but as their home is in the median price range, that would mean settling for significantly inferior accommodation. They may even have to rent in order to have a reasonable nest egg if they were to retire at that time.
ADDING TO GROWTH POTENTIAL
Alternatively they could do something now to add to their growth potential over the next ten years by using their property as collateral and borrowing to acquire additional property, which could be rented as an investment, with tax benefits, and most importantly, would also grow in value.
James and Susan decide on the latter plan and approach their bank manager for a loan to purchase investment property. But what are the risks? The first rule of investment is to protect existing capital. The bank would look at James and Susan’s position and should be happy to lend them up to 90% of their homes value of $220,000. At this level of borrowings they would have to pay for mortgage insurance which protects the bank’s position. But they want to remain fairly conservative, especially as a first time investment, and decide to borrow only 75% of their homes present value. Banks do not usually require mortgage insurance at this level of borrowing, as they perceive minimal risk, especially on investment in residential property.
AVOIDING BLUE SKY
If protecting our capital is our number one rule, then avoiding either "blue sky" optimism, or taking too "gung-ho" an approach to investment are important points to keep in mind.
The bank agreed to lend them 75% of the value of their home today, a $165,000 loan. But they still have a balance of $50,000, owing on their existing mortgage. If that $50,000 is deducted it leaves a borrowable amount of $115,000 which could be used as a deposit for a further investment property. The bank manager then has to establish that they can afford to service the total loan out of their income including the rent from the new investment property and the potential tax savings which would result from investment ownership. Providing those tests are met, the bank would lend them $115,000 "for any worthwhile purpose", to use a bank expression, in this case, as the deposit for another property purchase.
If James and Susan also borrow 75% of the value of the new investment property they intend to acquire, that would give them a total borrowing power of $385,000, which could be used to purchase properties worth $365,000 after allowing for acquisition costs such as stamp duty and legal fees. The next week they could go shopping for a property or properties up to $365,000 in total value.
BORROWING FOR INVESTMENT PURPOSES
Current Value of Home $220,000
Increase Borrowings to 75% of Present Value $165,000
Less Current Borrowings ($50,000)
Further Borrowings Obtainable on Existing Home $115,000
Plus Loan on New Properties at 75% of Purchase Price $270,000
Total Borrowing Power $385,000
Funds Available for Further Purchases After Purchase Costs
$365,000
You can see in the following figures with their new mortgage of $385,000 for investment property, with a value of $365,000 after allowing for stamp duty, legal fees and borrowing costs, which equate to around 5% of the purchase price of a median priced property, plus their home and existing mortgage, their total property holdings have increased to $585,000 with borrowing's of $435,000.
POSITION WITH NEW PROPERTIES
Home Investment Properties TOTAL
Value $220,000 $365,000 $585,000
Borrowings $50,000 $385,000 $435,000
Equity $170,000 ($20,000) $150,000
What they have done is increase their assets and liabilities, giving them greater exposure to future increases in values. Now they will receive capital growth on property worth $585,000.
THE FIRST FIVE YEARS
If they then do nothing for the next five years, what would their situation be? Applying the same principles and assuming values have increased at an average 8% per annum, their home would have increased to $323,000. We can assume that they have continued repayments on their home loan as they have done in the past, increasing their equity and reducing the mortgage.
POSITION IN FIVE YEARS FROM NOW
Home Investment Properties TOTAL
Value $323,000 $536,000 $859,000
Borrowings $24,000 $385,000 $409,000
Equity $299,000 $151,000 $450,000
The investment properties have increased at 8% per annum to $536,000. They still have the loan they took out to buy the properties at $385,000. If it were a principal and interest loan it would have reduced a little increasing the equity. We will assume that they borrowed interest only for investment purposes, so their total property holdings have increased to $859,000 with loans of $409,000 which is under 50% of the value of their properties. Looking at the total picture, this is a conservative level of borrowings. Their equity has increased to $450,000.
They have virtually achieved in five years what would have taken ten, if they had just continued paying off their home and left their equity passively non-productive. By putting that equity to work within fairly conservative limits, they have substantially improved their net worth. This could be achieved at relatively low ongoing cost, which is covered in detail in the next chapter. The actual ongoing cost to James and Susan works out to be less than leasing the average family car worth say $28,000 and which will fall in value, compared to owning $365,000 in additional property which will rise in value. There is no comparison - it is chalk and cheese.
After that first five year period, James and Susan are very satisfied with the results of their first property investment. They go back to the bank to show their manager what they have achieved, and seek to borrow for further investment.
This is after 5 years- Things start *snowballing* after this..
