I have had a question from a person who is 53 years of age, self-employed, owns his home, has no debts, wants to retire at 60 and has no Super. I don’t have any further information regarding income, savings etc. at this stage.
He claims that he wants to take advantage of an anticipated increase in Brisbane house prices and his question is that whilst he wants to borrow 100% using the equity in his home, should he borrow principal and interest or interest only?
From a purely mathematical point of view there is an argument for interest only, but from a human nature point of view I most often suggest principal and interest. Every case is different and a lot depends on the age of the client.
What is the difference between a mathematical and a human nature point of view?
Mathematics is a pure science. Human nature is not. As humans we have limited means but unlimited wants. In other words no matter how much we earn, it is never enough e.g. if the net contribution for a $500,000 property borrowing 100% was $150 per week principal and interest, $50 per week interest only, the client would contribute $5,000 less over one year.
Where do these surplus funds disappear to? With human nature, does the client have a further $5,000 to invest, or would it have just disappear and he still owes $500,000?
Years ago, I had an old neighbour who wanted to save $5,000 to buy a small “tinnie” to go fishing. He said Steve; “I spend $100 per week on cigarettes. If I give up smoking, I can save that $5,000 in one year.”
The question is, after one year, did he save $5,000? No, he gave up smoking but was still broke at the end of the year.
From a mathematical point of view are there any disadvantages against interest only? As banks consider principal and interest a lesser risk than interest only, they will usually lend at a lower rate for principal and interest.
As an example, consider a five-bedroom executive home I have at North Harbour, Brisbane for $522,000. Apart from a $5,000 deposit on the land, we borrow 100% including stamp duty, legal etc. ($542,000) and we will assume the client is on $100,000 per annum and this house will rent for $480 per week.
What is the difference between an interest only and principal and interest?
With interest only in arrears at 4.99% fixed at 5 years the client’s net contribution would be $38 per week but because he borrowed his costs, would still owe $542,000.
With principal and interest at 3.88% fixed for 2 years, the client’s net contribution would be $159 per week but at the end of the year, he would only owe $532,000 i.e. he would have paid $10,000 off his loan.
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Returning to the original question, the unknown in this question is this person’s income. If his income is sufficient, I would suggest principal and interest but if he wants to contribute little and rely on a capital gain he might be better off going interest only.
To reiterate, if this client who is on $100,000 per annum uses equity to buy a $522,000 residential investment home in Brisbane his only cash contribution is his initial $5,000 deposit on the land. He outlays nothing for stamp duty, legals or interest whilst his investment house is being built.
How much equity could this person expect to gain in the next 7 years?
I do not have an accurate crystal ball, but a capital gain of $250,000 in the next 7 years is feasible. It is possible, if using equity, to outlay only $5,000, contribute $38 per week and create $250,000 in 7 years.
It is not rocket science when you consider that the average price of a Brisbane house in 1972 was $15,000 and today is about $630,000.
If you are interested in buying an investment property and would like to know ‘how it works’ you are welcome to speak to me about your options. Please contact our office to schedule a free, no obligation consultation and find out if our service is suitable to your needs.
Steve Taylor
At the helm of Steve Taylor & Partners, Steve Taylor has been delivering expert advice and product knowledge to clients for over 30 years. Steve Taylor & Partners provide individuals, couples and families with the right strategies to create wealth and change their lives with solid bricks and mortar.
DISCLAIMER
Steve Taylor & Partners blog is opinion and not advice. Readers should seek their own professional advice on the above subject. The figures stated in this article were accurate at the time of publication. For up to date figures, please contact our office.
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