Trying to decide whether to buy a home to live in or an investment property can be tricky. Of course, the aim should be to own the property you live in at some point but it may be quicker to invest first, and work your way into buying your home as a second or third purchase.
Controversial? Well, not these days with the property markets in many popular areas stretching out of reach of many first home buyers.
More and more, buyers aim to get into a good property market as quickly as possible and leverage that purchase into buying their home. Get this right and you can have the best of both worlds – rent in your desired location for much less than it would cost to buy the property (and pay off the mortgage), and then invest in areas with good returns, capital growth and potential to build equity through adding value.
While personal requirements need to come into play and there's plenty of ways to utilise a home as a stepping stone to financial stability, another approach to consider is 'rentvesting' – either as a way to enter the property market, or flat out as a lifestyle.
Rentvesting is the term used to describe a situation where an individual will purchase an investment property before buying their own home, and rent where they would like to live.
Traditionally, in Australia we were programmed to work towards purchasing a home to live in as soon as possible. However, with the Sydney and Melbourne medians hovering around the $1,000,000 mark, first home buyers need $200,000 just to cover a 20% deposit, let alone purchasing costs which include $40,700 in stamp duty.
Other capitals are also starting to climb out of financial reach, so, let's consider the full range of options.
Strategy one – buy a property to live in
Using a scenario where you were aiming to be more realistic than aiming for the Sydney median, and you were targeting a purchase price of $700,000, with a $100,000 deposit this would require a loan of $600,000.
Note that you would also be required to pay stamp duty of $27,000, and with legal fees this could round out to $30,000 in extra costs, in addition to the $100,000 deposit.
Currently, interest rates hover around the 4% mark however your serviceability will be calculated with a buffer of close to 6%. This is the average long term Australian interest rate and banks use this rate in their calculations to protect their security and your ability to repay the loan over the usual loan period of 30 years.
An interest rate of 4% on a loan of $600,000 is $36,000 per year in interest. Usually, you would also pay the principle (the base $600,000) which we will assume for the first year is $10,000.
In addition to interest and the principle payment, we need to allocate funds for costs such as building and contents insurance and rates. Electricity, water, phone and other general costs are not included because you would have to pay these whether you were renting or living in your own home. For our example, we will allocate $4,000 to cover costs with the total as outlined in the table below.
That means, it will cost you $50,000 per year to own your own home.
For the purposes of a clear comparison, let's assume you're now going to rent the same property you were going to buy as your home. Based on a $700,000 price point, the rent could be approximately $600 per week which works out to be $31,200 per year.
Comparing the two strategies from a bottom line perspective is as follows.
It's important to note that paying your home off does not attract any tax savings, and you pay the interest, principle and expenses out of your 'after tax' salary. Taking this into account, you could equate the $18,800 to more than $25,000 in earned income depending on your salary level.
Strategy three – rentvesting
If you're renting where you want to live, instead of using your $100,000 deposit to purchase your home you could consider using the deposit to purchase an investment property . . .or maybe more than one. Using a clean example, let's assume you decide to purchase two properties at a purchase price of $400,000 with a 10% deposit of $40,000.
Note: There may be a lenders mortgage insurance (LMI) fee in this instance as usually for anything less than a 20% deposit, the banks require LMI to be paid to cover your risk of defaulting on the loan. Stamp duty on a $400,000 purchase would be in the ballpark of $14,000 in most states, but in Victoria, you would be looking at approximately $20,000, and this needs to be factored into your selection criteria.
Using this approach, you would already be ahead when comparing your progress against purchasing a home to live in as you would now have two properties worth $800,000 as opposed to one worth $700,000.
In an ideal situation, you should be aiming to purchase property in an area primed for capital growth (good infrastructure, largely owner occupied, established suburb, not in a suburb with all brand new properties bordered by greenfield land) where the rent covers costs. For a $400,000 property, this would mean rent of approximately $400 or more per week. A best case scenario would be where the rent more than covers costs, and actually delivers cash to you each week.
For our example, we will assume the property is neutrally geared, which means it just covers its own costs before tax deductions are considered. This means you would be ahead by $18,800 (the difference between the cost of purchasing your home as opposed to renting in the same location) and you would hold two properties to the value of $800,000.
Capital growth . . . or not
One of the key benefits of buying your home is the potential capital growth uplift. Keeping in mind the point that property prices decrease as well as increase, using a rentvesting approach you can have the benefits of capital growth, plus quite a bit more.
For ease of comparison, let's assume your investment properties have the same capital growth as the area where you had planned to purchase your home.
Assuming conservative and consistent capital growth (which never happens in real life), your investment properties will easily outstrip the performance of your home purchase. You will also have more than $18,800 in cash flow saved by taking the rentvesting approach, which can be placed into an offset account to effectively lower the interest payments on your investment properties (remembering that your rent is covering the interest payments on your investment properties).
Invest v home first – pros and cons
Looking over the comparisons above, buying an investment property first stacks up from a numbers perspective. Like all decisions though, there are pros and cons which should be factored into your decision making. Some of these include the points below.
• Enter the property market sooner. Investing first allows you to break into the property market sooner with a smaller deposit, as opposed to waiting several years until you are able to afford your dream home.
• Live the lifestyle you want. If rental prices allow, you can live in your dream home now and not have to compromise on location or features, and you don't have to worry about taking on the long-term commitment of a big mortgage.
• Build wealth. Investing first allows you to start building your investment property portfolio, which can be used to generate wealth for you and your family in the future.
• Save for your dream home. Owning an investment property allows you to save and simultaneously build equity through capital growth which can be used to purchase your dream home.
• Financial control. When you're renting, you can easily upgrade or downgrade to a different home if your circumstances change. For example, if you lose your job or get a high-paying promotion requiring a change of residence, there are no stamp duty expenses or legal costs to worry about.
• Suburb flexibility. If you're not ready to put down permanent roots in a particular area, rentvesting gives you the freedom to move around and even travel the world if you wish.
• Tax benefits. You can claim interest payments on your investment property loan as a tax deduction.
• Choose where to invest. Where you want to live and the best place to buy an investment property often won't be the same, so rentvesting allows you to be selective when it comes to choosing an investment.
• Against the 'crowd'. Buying an investment property before purchasing your own home can seem counterintuitive to many people.
• Dead money. The old adage that 'rent money is dead money' may be a deterrent for some people considering this approach. Hopefully, reviewing the example above will show that in the current market environment, paying interest on an owner-occupied home in some instances can be less cost effective.
• You don't own your home. As much as you may love your rental property, you don't own it. This can be especially difficult if you form an emotional connection to a house but then the landlord wants you to move out.
• You can't make it your own. Although a rental property might be vastly improved by a renovation project or simply a fresh coat of paint, remember that it's not yours to tinker with.
Tips for success if investing first
1. Decide whether rentvesting is actually a good option for you. Consider your goals – what are you hoping to achieve? Do you know you want to work towards buying your own home eventually, sooner rather than later, or just never. Yes . . you can change your mind down the track, but it really helps to consider your plan before you think about locations and properties.
2. Understand your numbers – consult a good mortgage broker and work out all costs including council rates, rental targets, include an amount for insurance and maintenance, along with stamp duty and LMI.
3. Steer clear of property 'advisors' who take commissions – you won't be receiving independent advice and that means you won't be getting the best possible choices from the market.
4. Buy property that will perform – property that will grow, and ideally will continue to have a pay off such as an older unit block or a property that can eventually be renovated, or rebuilt to accommodate a granny flat, duplex or townhouses.
5. Use a property manager – don't try to cut corners and manage the property yourself, particularly if you're new to this.
6. Speak to a property savvy accountant who will ensure you're claiming the right amount of tax deductions. They should recommend you have a depreciation schedule prepared for each property, and can advise on structuring your next purchases in the correct entities, for example a trust where appropriate.
7. Manage the admin – this can just be a 10 minute activity once a month, or a detailed process you set up to satisfy your curiosity. While you're using a property manager to manage the bulk of the management responsibilities, it's important to keep your eye on your property's progress. A simple step I take is to check the property management statements monthly and recording the base information in a spreadsheet. In this way I can see the activity over time, and can make a quick call to my property manager if I notice any changes.
8. Set your sights on your next target and prepare to buy again. You can set a target to achieve so you know when the time is right for your next purchase. The best target I have seen is using ratios to determine your next steps. For example set a 'Loan to Value' percentage point, and when you reach that point commence the purchase process again
Your Choice – Take Action
Ultimately, of course, the choice is yours. The good news is there's an upside to both options depending on your circumstances. The best advice is to map out your full range of opportunities, fully investigate the upsides as well as downsides, then take action knowing you have given the decision your full attention. Rest assured, you won't get anywhere sitting on the sidelines.