Is paying off your home loan quickly costing you?
For many Australians their first priority is to pay off their home and then to start planning for their future retirement. While this strategy has its merits, it also has its limitations. The main one being missed opportunity. Focusing solely on paying off your home without also focusing on strategies to build your wealth means you could be passing up opportunities that could actually get you to your long term goal sooner.
Let's look at a case study using two couples the Smith's and the Jones's. Both couples are aged 25 and have a combined income of $100,000 a year. They have both bought a property worth $300,000 and have borrowed $260,000 over 30 years at 7.37%.
We will assume an average capital growth in property of 7% pa. over 10 years. For the purposes of this exercise their income and interest rates will remain the same.
The Smith's want to pay off their home first before they start planning any further investment. They pay an additional $500 above their minimum repayment. Based on this programme they will have their home paid off in 15.5 years.
The Jones's also want to pay off their home, but also are keen to start building a property portfolio. They instead decide to buy an investment property for $250,000. It is currently rented for $245 a week. The rent increases in line with inflation at 2.5% pa. They borrow 100% plus costs to fund the purchase - $261,980.
Making some assumptions for depreciation the property costs them $106 a week after tax to hold - so roughly around $500 a month.
Let's see how the Smith's and the Jones's compare after 10 years.
With the extra repayments the Smith's home loan has reduced to $125,282, and their home has increased in value to $610,873 giving them equity of $485,590.
The Jones's house has increased to the same value as the Smith's but their loan has only reduced to $211,825 - giving them equity in their home of $399,048. But let's look at their investment property. Because the investment loan was interest only the balance is still $261,980, but the property has increased in value to $491,788, giving them equity of $229,808. So the Jones's combined equity is $628,856.
Therefore the Jones's wealth has increased by $143,266 more than the Smith's over the same period.
The other thing of course for Smith's is that if they now want to acquire an investment property similar to the Jones's they will have to pay $491,788 plus costs.
Of course these numbers are based on 10 year averages but 7% is below the 10 year average for major markets. See Residex Marketwatch April 2007.
The key learning is to be mindful of not focusing purely on one aspect of your wealth at the exclusion of other areas. Wealth creation for many will be a long term exercise and starting early can make significant difference in the future.
This information is provided in good faith but is not intended to be comprehensive and does not constitute advice. The above information is an example only and does not take into account market fluctuations or individuals specific circumstances. The ability to access the rates or repayments shown is dependent on individual circumstances and specific lenders policies. Attitude Finance accepts no responsibility or liability for anyone relying on this information.