Tuesday, 17 July 2012

Advantages of Using Finance

Nobody ever likes going into debt, but when you are buying a house, it is almost an inevitable outcome. But just because you are going into debt, does not necessarily mean it is a bad thing. Now of course with the average house price in Australia being around $300,000 (just an estimation), it would take someone too long to be able to save that much money up to buy a property outright. Even if you were able to save, not just earn but save, $1,000 a week, it would still take you 300 weeks, almost 6 years of saving up. Now that would take some serious dedication.

The solution to this dilemma is to go into debt, so that means you only have to save up for a portion of the time, and able to live in your dream home right away. So by saving up a 10% deposit ($30,000) you can use the bank's money to purchase your house.

But apart from buying your house to live in, purchasing an investment property it is also a great benefit to be able to use finance. Look at the following two examples, where Example A will not use finance, and Example B will use finance.

Example A - $100,000 saved up for a property, 8% Net Yield, 3% Capital Appreciation - Property Bought Outright

After 5 Years -

Property Value = $100,000 x 1.03^5 = $116,000
Rent Return = $100,000 x 0.08 x 5 = $40,000
TOTAL VALUE = $116,000 + $40,000 = $156,000

Example B - $100,000 saved up, 20% deposit for $500,000 property, 6% Net Yield (Yields tend to become lower percentages with higher value property). 3% Capital Appreciation. 7% Loan Interest Rate

Property Value = $500,000 x 1.03^5 = $580,000
Rent Return = $500,000 x 0.06 x 5 = $150,000
Existing Loan = $400,000
Interest Repayments = $400,000 x 0.07 x 5 = $140,000
TOTAL VALUE = $580,000 + $150,000 - $400,000 - $140,000 = $190,000

Example A - Value = $156,000
Example B - Value = $190,000
So as you can see from the above simple examples, using finance has increased the value of the investment in Example B by almost 22% compared to Example A. Doing similar calculations for over 10 years, you will an increase in value of 36% towards using finance.

Please note I have been very simplistic in these calculations, I assumed an interest only loan, and assumed the rent received for each property did not change over the 5 years. Also note the above examples are simply examples and are not based on any properties in particular.
One important issue you need to be careful with, is if your property does reduce in value over time, using finance will magnify the lost return, and you always run into the risk of having negative equity in a property. That means that the loan value is more than the property value. Which is always something to avoid because you never know when your circumstances might change and you might be forced to sell up a property.

Provided you are prudent with your initial property search, and you perform your own due dilligence and ensure you purchase a property in a good solid area that is not over valued, then you can see that going into debt is not always a bad thing, and by using leverage you will be able to receive a much greater return.

If you have any questions or comments feel free to email us at streamlineinvesting@gmail.com

Disclosure: The article is not to be taken as investment advice and the views expressed are opinions only.  Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.

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