Friday, 27 July 2012

2 Houses Are Better Than 1

One of the first things I noticed when looking to get a loan was just how much interest you ended up paying over the life of the whole loan. To purchase a $400,000 property on a 30 year loan would end up costing you around $1,000,000 (assuming interest rate of 7.00%). So you are effectively paying two and a half times the value of the property.

This didn't seem too appealing so I looked at the best way to reduce the amount paid in interest. The most efficient way I could determine was to reduce the loan period, which means increasing your repayments. To purchase a $400,000 property on a 15 year loan, it would only cost you approximately $650,000. Saving you $350,000! This is almost enough to buy the same property again. I then wanted to figure out other ways to be able to escape this need to pay such a high amount in interest repayments.

Unfortunately, to pay off a property quicker, you need to increase the repayment amount. In the example above, the 30 year repayment was $2,660 and the 15 year repayment was $3,600. So where would you come up with the extra $1,000? Then I remembered sitting with my group of friends and talking about investing in property.

I have talked in another post about the benefits of purchasing a property with someone else, where simply the increase in repayments by using the combined incomes, significantly reduces the loan term and effectively reduces the interest paid. But now I am contemplating something different. Let's say two people purchase a house together and use their combined incomes to pay off the property ASAP. Then the same two people buy a second house, again paying it down ASAP. So at the end of the day, each person has a house each.

There would be a lot of complications between what is an equivalent house for each to own and there may be some issues between the two if one believed the other got the better end of the deal, but avoiding all the emotional aspects, and looking at the pure financial side of things:

Using the following inputs:
- Each person has a monthly saving of $3,000
- Initial cost of a house is $300,000
- Capital Appreciation of 2% Per Annum
- Interest Rate of 7.00% Per Annum

Situation 1 - Each Individual buys their own property

Using this formula in excel - NPER( ) - the repayment period will be 151 months for each person, so a total individual cost of $453,000.

TOTAL COST - $906,000
TOTAL PERIOD - 14 Years 7 Months

Situation 2 - They buy 2 properties together, one after each other

So the total repayment is now $6,000 per month.

1st House will take 60 months to pay off. A total cost of $360,000

To obtain an equivalent house for the 2nd property, assuming the capital appreciation of 2% per annum, the house price of the second house would now be $331,200.00 (after 5 years)

2nd House will take 67 months to pay off. A total cost of $402,000

TOTAL COST - $762,000
TOTAL PERIOD - 10 Years 7 Months

So as you can see in Situation 2, the total cost is $144,000 cheaper than Situation 1. And also the total period of being in a loan is 4 years less, with both people at the end of the day essentially obtaining the same thing.

Keep in mind, this is a very simplified example, and there is a lot I have not taken into account. Firstly, if you do buy a property together, you will only be able to use one FHBG and stamp duty exemption or whatever else your government offers you. Also there is the option of, for instance, say you both purchased a 2 bedroom property, then in Situation 1, each person would have a spare room which they could perhaps rent out for extra repayments, whereas this does not occur in Situation 2, until the second house is bought. It is also important to note the preferred option is typically dependent on the capital appreciation of the property, using a low rate (as I used 2.00%) will generally have Situation 2 preferred, but a higher rate (over 5.00%) will generally have Situation 1 as the better alternative financially.

I have developed a spreadsheet which takes all the above into account and allows for a fairly accurate comparison between the two different methods.

If you would like a free copy of this spreadsheet, please click this link Spreadsheets

No comments:

Post a Comment