The great Australian dream seems to be slipping away from so many of us. Property prices in our major cities are sky-rocketing and consumer debt as a function of our income is at an all-time high. Statistics suggest that an increasing number of Australians in the Gen X and Gen Y age group have given up on the idea of owning a three-bedroom brick veneer on a quarter acre block. The family home is now viewed as a monthly expense, rather than a purchase. These reasons are among many that have seen the Reserve Bank of Australia (RBA) lower the prevailing interest rate to all-time lows over the past few years, and the general opinion is that this is a great time to borrow…. or is it?
Let’s explore an alternative concept: this is not the best time to borrow, it is the best time to pay off your debts..
I’d like you to bear in mind that it is an entirely different conversation if you are trying to buy your first home as opposed to someone who has a home loan already. I’ll address each situation separately to avoid confusion…
Saving for your first home:
Ok.. so you’re madly trying to get into the property market. Your thought process is probably along the lines of: “I just need to get into the market” which can be a bit like trying jump onto a moving train. It is especially more important if all of your friends are already on the property merry-go-round. It is especially more important if all of your friends are already on the property merry-go-round…. because you don’t want to be the only one at the BBQ yet to experience the joys of property ownership.
Interest rates are at insanely low levels at the moment, but you need to remember that this is because property prices are at insanely high levels. Let me introduce you to some investment fundamentals…. What goes up must come down (ok, that’s a law of physics, but when you add the next bit, it becomes an investment fundamental) and what goes up, will probably go down. So if interest rates are low, and property prices are high, what do you suppose will happen when your interest rate goes up and your property valuation goes down? That’s right… your dream home will become the bain of your existence every month when the bank wants some of their money back.
Property DOES go down: I’m going to introduce another little concept to you too… I’m tired of hearing people say “property doesn’t go down” because that is bullshit.
There are so many people that have lost money investing in property, mainly due to poor borrowing decisions and poorly informed investment decisions. Property valuations fluctuate the same way that shares do, it’s just not as often or as obvious. My own house has fluctuated between $550,000 and $650,000 in the past year. It doesn’t matter because we aren’t selling it, but because it gets valued every month (with our AssetLab personal finance software) I see the fluctuations. If you only get a valuation every three years, then you are unlikely to be aware of this. The question I have is, if you auctioned your property every day, would you receive an ever increasing price for it? No.
Be realistic about your first home: If you want to borrow to invest, you need to be more clinical than if you want to buy your first home. Your first home needs to be exactly that… your first home. Don’t be disappointed if it doesn’t have a yard big enough for the kids to ride their bikes, especially if you don’t have kids yet. In a low interest rate environment there is no question that your borrowing power is increased so it can be quite easy to fall into the trap of borrowing more. So what if it doesn’t have a double ensuite? Heaven forbid, it might not even be in your most desired suburb! Buy your first home, not your dream home. Most people spend less than five years in their first home so go with something that you can afford not something that you want to retire in.
Banks lie: That’s not true, they don’t, but my point is that just because the bank approved you for a $1,000,000 loan doesn’t mean you can afford it. I had someone in my office today that had been approved for a $700,000 loan.. but couldn’t quite understand how they could afford the repayments associated with such a loan. Fortunately, they were working with a great broker who told them that he thought they could afford $430,000. What you are approved for is different to what you can afford, which is also different to what you should borrow. Banks aren’t in the business of lending money to people that can’t afford it (I think) but they are looking at the maximum, which doesn’t take into consideration the trip to Fiji that you have planned, or the fact that you spend enough money on clothes to end third-world debt. Know what you can spend on a mortgage and stick to it.
There’s no magic answer: I am constantly asked, ‘what investments should I use to save for a deposit?’ and my answer is almost always the same… your bank account. You need to implement a sound cash-flow management plan (see my YouTube video: Get a plan, get a coach) to save the money. In this low interest rate environment, most short term investments are returning two-fifths-of-bugger-all, so the most powerful action you can take is to save more. That means that you need to either earn more, spend less, or both.
Trying to pay off your home:
I am in the unenviable position of owing more on my house than what I paid for it. That is because we have refinanced to consolidate bad-debts, and once more to renovate. As someone that yearns for the day that I will be debt free, hearing professionals say things like “with interest rates so low, now is a great time to invest..” I must admit that I get a bit pissed off. It’s actually the best time to pay your debts off. Think of it this way, If you make an extra loan repayment of $1,000 this will have a greater impact on a 4% loan than it would on 7% loan, because more of your money goes to paying off your principal.
With this notion in mind, today we decided to crunch some numbers to prove (or otherwise) my hypothesis:
If you start a 30 year loan for $350,000 at 7%, your repayments will be about $2,400 per month. At 4%, your repayments are about $1,900, but if you pay the $2,400 on your 4% loan, it will be shortened by about 13 years and a handsome $130,000ish saved in interest.
Let’s look at it the other way.. at 4%, for $2,400 per month you could borrow $487,000 over 30 years and pay what is known in the financial advice community as ‘a shit-load’ more interest, with no breathing room. That is to say, that if interest rates went to 7%, your repayments… minimum repayments, would become $3,250 or so. That’s an extra $850 per month and a stack of interest.
Make extra payments now: What many people don’t realise, is that your repayment is not a constant combination of interest and capital… the first payment is almost entirely interest, and the last is almost entirely capital. So the earlier that you start making extra repayments the better!
Fully consider consolidation: As enticing as it can be to change your $1,000 per month personal loan repayment over for an extra $200 in home loan repayments because of the lower interest rate in your home loan, remember that the big difference isn’t the rate.. it’s the timeframe. You might pay 4% instead of 12%, but you’ll pay it over 25 or 30 years instead of 5, so you will actually be paying more interest… a lot more. This is a short term gain strategy that should be used deliberately, and is generally not a smart decision despite how right it feels. You’ll be out of debt sooner if you don’t refinance short term debt into your home loan. It is likely that if you focus your surplus cash flow on your SHIT debt (Short-term High Interest Thoughtless debt) first. If you have an extra $100 per week to utilise, paying it off a 5 year loan regardless of the interest rate, is likely to be more effective than paying it to a 30 year loan.
Offsets need more thought: An offset account, where you can store money and in return pay no home loan interest can work. Having your pay put into an offset account, and paying your bills from it is a tried and true strategy that we have recommended for many of our clients with great success… but be wary, sometimes the advantage is minimal. If you don’t have a sound cash-flow management plan, the strategy just won’t work, and sometimes, the savings don’t cover the extra cost of maintaining an offset facility.
The point of all of this is to remember why we are in debt in the first place…. Debt is to help us buy something that we can’t yet afford. Debt is meant to be paid off, it is not a perpetual expense. If you can be sensible with what you borrow, and manage your cash flow in order to maximise the surplus income available to use in a sound debt reduction strategy, you will be better off.
Don’t view low interest rates as an excuse to borrow more, but as an opportunity to smash your debt down, so that your life will be easier when rates go back up.
Disclaimer: The lawyers want me to remind you that this does not constitute financial advice because I have not taken into consideration your personal situation…… etc etc… check my website for the full disclaimer, but just don’t act on the information here without considering your own situation and objectives.