Part 2: Which is better for financial freedom -buying a home or renting and investing?
12 Sep 2013
By Darren Higgs
In my previous blog, I suggested that renting and investing could be a better financial option than buying a home outright.
To demonstrate this, below is an example of this reasoning. Please note, everybody's circumstances are different, so please seek advice for your personal situation.
Fred is 'Mr Average' who asked for financial advice. Fred's situation is:
- Fred's employment income is $72,800, the average Australian salary;
- He is considering whether to buy a home for approximately $400,000, purchase an investment property for $400,000 or invest into a share portfolio for $400,000;
- If Fred decides to take the property option, it will be an existing dwelling in NSW;
- Fred's parents have offered to be a guarantor for his loan, using their own home as security;
- If Fred selects the investment property, the gross rent will be 4.5% p.a. I have assumed that the investment property expenses will be 30% of the gross rent. The assumed interest rate on the loan will be 6% p.a., although rates are currently lower than this.
- Of the $400,000 investment property purchase, $150,000 relates to the actual building. Depreciation and capital write-off will be 2.5% of the building cost;
- If Fred decides to gear into a share portfolio, the dividend yield will be 4.5%, with all dividends being fully franked;
- Fred saved 10% as a deposit for the property or shares but did not consider the entry costs for property for example stamp duties and legal costs which will get added on to the loan. If he buys his home, the costs will be around $4,010. Note there is no stamp duty as it is his first property purchase and the amount is below $500,000. If he purchases an investment property, the costs will be $17,500 as he will have to pay property stamp duty. Although this increases Fred's loan-to-value ratio, he can still borrow this amount, as his parents are guarantors, meaning Fred will not have to pay the bank's lender mortgage insurance;
- Fred wants to create equity in this property. He will make principal and interest repayments and the principal repayment will be 1.5% of the loan amount;
- If Fred purchases an investment property or share portfolio, he will rent a place for himself. Fred will pay the same rent he receives from an investment property.
Taking the above into account, Fred's cash flow and income tax position looks as follows:
|Gross Income Sources||Buy Home||Rent & Invest in Property||Rent & Invest in Shares|
|Employment income|| $72,800|| $72,800|| $72,800|
|Dividends (fully franked)||$0||$0||$18,000|
|Total Gross Income||$72,800||$90,800||$90,800|
|Gross Up-Imputation credits||$0||$0||$7,714|
|Total Assessable Income||$72,800||$90,800||$98,514|
|Depreciation & Building Write-Off||$0||$3,750||$0|
|Rental Property Expenses||$0||$5,400||$0|
|Interest Expense on Gearing||$0||$21,600||$21,600|
|Calculation of Tax Payable |
|Income Tax Payable||$15,207||$11,063||$16,544|
|Less: Dividend Imputation Credits||$0||$0||-$7,714|
|Less: Low Income Tax Offset ||$0||-$99||$0|
|Add: Medicare Levy||$1,092||$901||$1,154|
|Total Tax Payable||$16,299||$11,865|| $9,984|
|Cashflow Items |
|Less: Loan Repayments (Principal & Interest)||$27,301||$28,313||$27,000|
|Less: Property Expenses||$5,400||$5,400|| $0|
|Less: Rent Payable||$0 ||$18,000||$18,000|
|Amount for living expenses each year||$23,800||$27,223||$35,816|
In this example, buying a home results in a worse cash flow position each year whilst gearing into shares provides the best cash flow result. However, we know that people buying property will eventually repay the loan, which will help their cash flow. Therefore, 'rent and investors' need to make good use of their surplus cashflow.
Let's say Fred wishes to purchase the investment property so that he can use this as security for borrowing later in life. Fred also wants to purchase a second investment property within ten years. Below is an indicative plan to get the cashflow working for him, based on the assumptions above:
Property Value/ Equity Position
As you can see, you can start to use investment growth and debt reduction as a way of increasing your equity. This will help you on the path to financial freedom and enable you to purchase further investments later on.
What this example doesn't show is how to plan a cash buffer or insure against bad events to minimise risk, this is where getting financial advice can help.
In my next blog, my friend will discuss how he used the 'rent and invest' approach to ultimately buy his dream home, with no home mortgage, at age 40.
To learn more about Darren, view his online profile.
If you are seeking financial advice please contact us on 1300 308 440 or enquire online.