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Why the next property you buy is the most important one
Season 1
Episode 127
Published 5 years, 10 months ago
Description
This blog’s title is a bit deceptive, because every property you buy is important, for either lifestyle or financial reasons.
I contemplated using the title: “why the first property you buy is the most important one”. But the reality is, if you have made a mistake on your first property, you can always start again.
The general theme of this blog is to demonstrate that the compounding impact of buying the right property is critical to understand.
Why is it so important?
Let me explain using an example:
Rick and Karen are buying their first home and are comparing two properties. Property A is considered to be investment grade and has great growth prospects i.e. 6% p.a. growth rate. Property B is a newer property but has inferior growth prospects and barely keeps up with inflation – growing at 1% p.a. Both properties cost $750,000. Rick and Karen need to borrow $700,000.
After 5 years of principal and interest home loan repayments, the balance of Rick and Karen’s loan would have reduced from $700,000 to approximately $622,000. The value of Property A would be approximately $1 million, and Property B would be $790,000. If Rick and Karen purchased Property A, they would have $378,000 of equity. However, if they purchased Property B, would have less than half the equity i.e. $168,000. That is a substantial difference of $210,000!
But it’s how this difference compounds that’s most important
If in 5 years’ time, Rick and Karen were contemplating upgrading their property to buy a larger family home, the differential in equity will have a substantial impact on their budget.
Assuming that they want to borrow a maximum of 80% of the new home’s value, a deposit of $378,000 will allow Rick and Karen to spend up to $1.45 million (allowing for 6% for costs including stamp duty).
However, a $168,000 deposit will only allow Rick and Karen to spend $650,000, which is less than their current property value! If they buy for $1 million, they will have to borrow 90% of the value and pay for mortgage insurance (which will cost over $35,000!).
Therefore, using this example, the difference between buying the right versus wrong property could be the difference between being able to take the next step (and buy a family home), or not.
It should be noted that this equity gap will continue to grow. If Rick and Karen purchased Property B, they may be forced to buy their larger family home in a suburb further away from the CBD (due to budgetary constraints). This will mean they will have a lower value asset that attracts a lower growth rate – the equity differential could be massive, as charted below.
And you can put that equity to work
To make matters worse, not only will buying the right property help Rick and Karen build more equity in their home, but they will be able to leverage that equity to build an investment portfolio. This could include borrowing to buy an investment property or invest in the share market.
Should you buy a property purely to make a quick profit?
No. In order to minimise your risk, it’s important to buy an investment-grade property that has sound long term fundamentals. A property that is well positioned to generate an above average capital growth rate over the long term. That must never be compromised.
However, if your goal is to upgrade or invest in the shorter term, then it does make sense to pick a property type or location that is expected to deliver a r
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