How does the location of your house drive your investment strategy?

The location of your “great Australian dream” can dramatically alter your wealth building activities and as such, you must take this into account when developing your investment strategy.

Homes are typically not purchased with the sole or dominant reason of building wealth as there are many non-financial, lifestyle factors that influence where we live.

However, that is not to stay that the decisions you make will not have any impact on your investments.

In this blog I will discuss how the location of your home can impact on your ability to meet your retirement goals.

• The size of your home loan and your cash flow

Many clients wonder if they should repay their home loan in full before they start investing.

If not, how much should your home loan be before it’s prudent to start investing?

The answer to this question depends on many factors: 

The location and type of home – what do you expect your home to be worth in 10 years?

Or 20 years? If your home is an investment-grade property, your home loan will become immaterial over time, even if you do not repay one cent.

I will demonstrate this using an example. William’s home is currently worth $1 million and his home loan is $700,000.

If William’s home appreciates in value by 8% p.a., it will be worth $4.66 million in 20 years.

If the home loan balance is still $700,000, the loan to value ratio (LVR) will be a conservative 15%.

After taking into account inflation, $4.66 million in 20 years is equivalent to $2.58 million today.

And inflation will eat away at William’s home loan too – $700,000 today is equivalent to $390,000 in 20 years.

If William’s home was worth $2.58 million today with a home loan balance of $390,000, how important do you think it is for him to repay his home loan and delay investing?

If William doesn’t plan on retiring for say 20 years and his home is well-located, then repaying his home loan is not that important. Starting investing is more important.

Conversely however, if you do not expect your home to enjoy a lot of capital growth then repaying your home loan becomes more important.

• Size of your home loan and cash flow

Another factor to consider is your interest rate exposure.

Is your home loan so large that you are more exposed to interest rate movements?

That is, someone with a $2 million home loan will be more susceptible to interest rate movements.

Principal and interest repayments on a $2 million home loan will be approximately $129,000 p.a. today.

However, if interest rates rise to say 8% (like they were in early 2008), the repayments will increase to $176,000 p.a. – an extra $46,000 p.a. after-tax.

That is a lot of money to “find”.

Therefore it would be important for this person to reduce their home loan balance before they begin investing.

The same is true for your LVR too.

If you do not have a lot of equity in your home (say you have borrowed 95%) then you should spend a bit of time repaying your home loan and consequently building equity before you invest.

• Other investment assets

Do you already have investment assets and a healthy super balance? 

If so, repaying your home loan could be a good priority.

However, if you don’t have any investment assets then you need to start investing as soon as possible so that you can benefit from the power of compounding growth – it rewards those that start early.

The table below sets out how an investor is rewarded for time in the market.

For example, in the first 5 years, the property increases in value by $235,000.

However, between years 20 and 25, the property’s value increases by over $1 million – being four times more than in the first 5 years.

Albert Einstein is credited for saying:

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”

That is why it is important to start investing as soon as practical.

Value of a $500,000 investment assuming a compounding annual growth rate of 8%

Year Projected value Change in value:

0 500,000 –
5 735,000 235,000
10 1,080,000 345,000
15 1,587,000 507,000
20 2,331,000 744,000
25 3,425,000 1,094,000
30 5,032,000 1,607,000

Get some equity to work hard for you  

What if your home is not well-located and as a result you do not expect to enjoy much capital growth?

If that is the case then it’s even more important for you to start acquiring some high quality growth investments.

That is, it’s more important to acquire assets than repay your home loan.

The reason being is that in the absence of acquiring high quality investment assets; the only way you are going to build wealth is by repaying your home loan using after-tax income.

That is a very slow and ultimately unsuccessful way to build wealth.

Relying on equity to fund retirement?

Be careful

Some people think they might realise some equity from their home when they downsize their home during retirement.

For example, they might have a large 4-bedroom home that may feel very empty and hard to maintain when the kids finally move out.  

In this situation, many people expect to downsize their home and buy something smaller and maintenance-free.

They might be under the illusion that they will realise some equity during this process and rely on that to help fund retirement.

However, what typically happens in practise is that whilst people downsize in term of accommodation size, it does not necessarily translate to a downsize in monetary value.

People become accustom to living in certain locations with good amenities and they don’t want to lose this.

So they end up purchasing, for example, a newly built, well-located townhouse in a prime suburb which may cost a similar amount to their existing home.

If this is true, little equity (cash) will be realised as a result.

My advice is that whilst you may actually realise some equity (cash) from a planned future downsize, I would not rely on it when developing a retirement strategy.

You are better off assuming that no cash will be realised.

If you are wrong, great.

But if you are correct, then your retirement strategy still works.

What should you do now?

If you do not expect a lot of future capital growth from your existing home and you do plan to upgrade it in the future, consider doing it sooner rather than later (if it’s possible and safe to do so).

I don’t mind clients upgrading their home if it means that they have a better “quality” property.

In the long run it will help them build wealth.

If you do not expect a lot of capital growth from your existing home and you are happy where you are (i.e. no planned upgrade), then please ensure that you are actively investing in growth assets.

If you are not, do so as soon as it’s possible and prudent to do so.

If you have a large home loan and are worried about it, have a think about the factors I have mentioned above.

If, for example, you feel confident about the future growth in value of your home then perhaps repaying your home loan is less important than building wealth through investing.

Try and avoid the “emotional” decision e.g. some people just don’t like to have a home loan and prioritise repaying above anything else.

But that is often an emotional decision rather than a practical one.

Emotional financial decisions are almost always sub-optimal decisions.

This blog was originally published in July 2018 and has been republished for the benefit of our many new subscribers.

from Property UpdateProperty Update https://propertyupdate.com.au/how-does-the-location-of-your-house-drive-your-investment-strategy/