How to pay off your home loan in 10 years

Name: Bob and Irene
Household gross income: $130,000
Children: 1
Home value: Purchased for $650K, now worth $750K.
Home mortgage: $500,000, refinanced recently at 4.5% interest rate. They currently pay $3,000 per month towards their mortgage.
Savings: $20,000, in a savings account.
No credit cards, no debt.

In this case study, Bob and Irene have an ambitious goal of paying off their mortgage in 10 years. They currently pay $3,000 per month towards their mortgage, which is what they paid before refinancing. Looking at it very simplistically, if they want to repay it in 10 years they needs to increase their monthly repayments pay to $5,000 (assuming 4.5% interest rate), which is an extra 2,000 per month! Obviously this is not possible given the couple’s current circumstances.

They wondered if they could somehow use the equity in their home to invest in an investment property with a view to help them with their goal. So many people think that they need to fully repay their home loan before they can invest in property, so Bob and Irene’s line of thought is on the right track.

Borrowing Capacity

As it currently is, their financial profile will allow them to borrow $540,000 to invest in property. We could boost their borrowing capacity to about $750,000 by converting their home loan to interest only repayments, as some lenders are happy to take actual repayments towards servicing. However this would be increasing the financial risk for the family and I would not recommend this approach.

Using equity to invest.

There is about $100,000 of equity in their home that can be used to help them acquire a property and still keep the overall Loan to Value Ratio (LVR) below 80%, which is a LVR that most banks are comfortable with. I would suggest to extract this equity by setting up a Line of Credit (LOC) of $100,000 secured by their home. LOCs are fully transactional accounts with a limit to spend. A bit like a giant credit card but with home loan rates.

The LOC will be used to fund the deposit on the property, stamp duty, legal costs, etc…

A summary of the structure would be as follows:

Finding a property

I would suggest that our couple invest in a vibrant, up and coming location with substantial infrastructure spending, a multi industry approach and a strong population growth. For the purpose of this case study, and to allow for a great property within the budget constraints of Bob and Irene, I have chosen a 4 bedroom house and land package property in a great location in the Newcastle area. This type of product is great for Bob and Irene because stamp duty only applies to the land portion of the purchase and also because there is currently a $5,000 stamp duty rebate from the NSW government for new properties. This will substantially lower acquisition costs. The property purchase price is $525,000 and the anticipated rent is $560 per week. This is higher than the average rent in Newcastle but this property is ideally located by a sandy beach and can easily command such a rent. At 6% interest rates, this property is cash flow neutral. So, in the current environment where interest rates are much lower, this property is cash flow positive.

Financing the property

As our couple have only $100,000 available in their LOC, the new property will have to be financed by borrowing 90% of the purchase price. At 90%, Lenders Mortgage Insurance (LMI) is applicable. LMI varies depending on lenders but is around $9,300. This one off premium will be added to the loan and will increase monthly repayments by about $35.

The total needed to fund the acquisition is about $59,000 as follows:

This amount is funded from the LOC.

Safety buffers.

During construction of the house, interest will be payable on the amounts drawn and will amount to about $8,000 over the period of construction. Again this will be all paid out of the LOC. So by the time the property is ready to be tenanted, Bob and Irene will have used about $70,000 of their LOC. This includes interest on the LOC itself. As a result they will have a $30,000 “buffer” or unused funds in their LOC when the first tenant moves in.

All rents collected, expenses (council rates, managing agent fees, interest on the investment loan, tax refund, etc..) are paid into or paid from the LOC. Since the property is cash flow positive, the balance of the LOC will decrease over time. If interest rates increase to 6% then the property is cash flow neutral and the balance of the LOC remains the same over time. The $30,000 buffer is designed for unexpected expenses and for peace of mind for Bob and Irene. In our case our couple also have $20,000 in savings which they will keep for personal expenses. So they have 2 buffers, which should allow them to sleep soundly at night!

Cross Collaterisation.

By structuring the loans in this manner, we avoid cross collaterisation of the 2 properties, which is never advisable as it creates issues in the future, especially when trying to sell one of the properties or when refinancing. Banks love to cross collaterise properties because it is easier to do and it makes it harder for the client to move to another lender. The client becomes a “sticky” customer…

This structure also allows for the creation of a buffer, which is not only a good risk management tool, but is also tax efficient (LOC interest fully tax deductible) and allows for easy financial management of the property.

Capital Growth.

According to the BIS Shrapnel – Australian Housing Outlook 2014 – 2017, the Newcastle area has grown by 10% in 2014 and is tipped to increase in value at a rate of 7% per annum over the next 2 years. It is hard to predict what will happen beyond the short term. So investing in an area where the fundamentals are sound is the best we can do. At 7% growth, the property will almost double in value in 10 years. If the property is sold, capital gains is payable as follows:

I have assumed that the tax rate is 22.5%, which is the highest rate for individuals who hold a property for over 1 year.

Let’s look at the home loan itself.

At their current repayment rate, the balance of the home loan will be $330,000 in year 10, assuming that current interest rate on their loan remains at 4.5%. I recommend that:

  1. They move their $20K into an offset account, which will help reduce the time it takes to repay the loan.
  2. Move to a fortnightly repayment schedule, which will also speed up the time it takes to repay the loan. This is because they effectively repay an extra month every year.
  3. Pay an extra $50 per week into the home loan.

As a result of the above their loan balance will now be $228,400 in year 10.

This means that our couple could repay their home in year 10 by selling the investment property provided the property growths by about 5.0% per annum on average.

If interest rates go up during this 10 years, and there is a good chance that they will, then the numbers will look different. If we assume an average of 6% interest rate over the 10 years then the balance of their loan in year 10 will be $305,600, and in order to repay their home loan then, our couple will need their investment property to grow by about 6%.

Further considerations

Although it is possible to use investment properties to repay home loans, investment properties are not “designed” for that purpose. In this case study, the property helped to repay the home loan, but the home owners had to increase their repayments to achieve the desired outcome.

Growing wealth is all about planning, leverage and time. If Bob & Irene decided not to sell their investment property in year 10 and keep it until year 15, results would be:

By keeping the property a further 5 years, at 6% capital growth profit would increase by 80%, and at 7% profit would increase by 85%. So Bob and Irene will need to decide if they should sell the property in year 10 and repay their home loan, or keep it and grow their overall wealth. I know what I would do….

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