Introduction

Using home equity to invest is a powerful investment strategy, but it is not suitable for everyone.  In this case study, we compare buying an investment property with home equity against buying one without it, so your clients can see the differences in timing, tax paid, debt levels and cash flows, and make an informed decision.

The clients

In this case study, Cynthia and Tony, want to purchase an investment property.  They do not have a deposit saved, yet, so they are considering whether to use the available equity in their family home so they can buy the property immediately. To help them decide, we will compare:

• Scenario 1: Purchasing the property immediately at a value of $400,000. To fund the purchase, 20% of the property value (i.e. $80,000) is borrowed against the home and 80% of the property’s value (i.e. $320,000) is borrowed against the property itself; and
• Scenario 2: Purchasing an investment property once they have saved enough to cover the property’s deposit and acquisition costs.  To fund the purchase, 80% of the property’s value is borrowed against the property itself and no home equity can be used.

We will also make the following assumptions:

• New investment property: Valued $400,00 in 2018/19 dollars, then indexed by 2.5%pa;
• Investment property loan:
  • Principal and interest loan
  • Interest rate 5.8%pa
  • 25-year term
• Home equity loan:
  • Principal and interest loan
  • A lower interest rate of 5.2%pa
  • 25-year term
• They have a home with an outstanding mortgage
• They would like to keep a $10,000 cash reserve
• Savings for the deposit and acquisition costs must be made in cash
• Any excess funds not required for the home purchase or other expenses can be saved in a joint balanced fund outside super with 2.13%pa capital growth and 3.68%pa income (including franking credits and after fees)
• CPI 2.5%pa
• AWOTE 3% pa.

Results

The following results show Cynthia and Tony different aspects of their strategy, which can help them decide which strategy works best for them.

Projected net wealth at the end of the analysis

After 20 years, it is projected that using the equity in their home to purchase the property immediately will increase Cynthia and Tony’s net wealth by about $35,000 (present values) more than if they waited to purchase the property later when they have saved for a deposit.

However, that is not the end of the story. Further analysis into the detailed cash flows gives insights into other factors that contributed to the outcomes.

Property purchase year and actual value

If Tony and Cynthia save up their deposit and acquisition costs, then it is projected that the earliest they can buy the property is 2021/22, or three years later than buying the property immediately.  Furthermore, we have assumed that the property value grows by 2.5%pa, so by the time they make the purchase, the value has increased from $400,000 to about $431,000, and the 80% that they borrow against the property has increased from $320,000 to about $345,000.

If Cynthia and Tony have an opinion about the future of property prices or interest rates, knowing that they will need to wait at least 3 years to save a deposit may help inform their decision about which timing works best for them.

Total debt levels

This chart shows Cynthia and Tony’s total loan balances outside super, which consists of their home mortgage and the new property loans.

For the first 10 years, their debt levels are higher in the first scenario because they borrow more and borrow sooner.  However, this head start ultimately means that in 20 years’ time, their debt levels will be lower.
Tony and Cynthia can also see that if they purchase their property immediately, then their debt levels in 2018/19 will be about $608,000, rather than about $211,000 (which is just their home mortgage). This gives them specific information to help them decide if they are comfortable with the level of debt they would need to take on at this time.

Minimum annual loan repayments

Their total loan repayments are about $3,900/year higher when they borrow against their home. In scenario 1, their total mortgage repayments are about $29,998/year and consist of $24,274/year for their normal mortgage and $5,724 for the home equity loan.  In scenario 2, their total mortgage repayments are projected to be about $26,140/year.
It is also worth noting that it is projected that the scenario 2 repayment is higher than the normal mortgage in scenario 1 because even though the 80% LVR is the same, the property value has increased while they were saving, so they need to borrow more against this loan.

Tax paid

This chart shows the difference in total tax paid outside super, including personal tax, Medicare levy and deductions from the property loan interest repayments and property expenses.

Comparing the strategies, we see that when purchasing the property immediately, their combined tax paid from 2018/19 until 2021/22 is less than that for the alternative strategy. This is because interest paid on the investment property's loan and the home equity loan, as well as running expenses, are tax deductible.

Available cash for other investments

By using the equity in their home, Cynthia and Tony do not have to put aside excess funds to save for their property deposit, so they can direct more funds into alternative investments sooner.
The following chart shows the deposits to their new balanced fund when the property is purchased immediately.  Once the property is purchased in the first year, they have enough excess cash to make deposits of around $20,000 a year.

The following chart shows the deposits to their new balanced fund when the property purchase is delayed. No significant deposits are made until 2022/23, after the property is purchased.

This chart shows their cash balances while they are saving for the home deposit in scenario 2.  It drops to their $10,000 reserve in 2021/22 when they spend it on their property purchase.

At the end of 20 years, the projected balance of this investment is $1,092,000 for scenario 1 and $1,078,000 for scenario 2.  So the different schedules of deposits boosts the balance in scenario 1 by about $14,000 (present values).

Although, in reality, Cynthia and Tony may not wish to direct all their excess cash to this fund, it illustrates how much excess cash they have and when. It also shows the impact of being able to deposit more funds in an investment with a higher return sooner or later.

Conclusion

To help Tony and Cynthia decide whether or not to use the equity in their home to fund their new investment property, it is useful to show them how each scenario affects the timing of their purchase, debt levels, mortgage repayments, tax paid and excess funds, and the effect of these on their longer-term net wealth.
This can easily be done in Optimo Pathfinder using our new ‘Special borrowing’ feature and explained with our improved comparison charts.

 

DISCLAIMER/WARNING

This is a case study and only contains general information, so it should not be used as financial advice because it uses sample data that cannot reflect an individual’s real and complete circumstances.

Run this case for yourself: Login here then go to the start step and select the Sample Case: Cynthia and Tony.

If you don't have an account with Optimo, simply sign up (this is free - you will receive a 30 day trial case), and then at the Start step, choose the ‘Cynthia and Tony’ sample data.
 

 

A popular subject often talked about at family barbecues is; "should mum and dad downsize when they get older?" Often it's assumed that downsizing is the best option moving forward. To test and possibly challenge this we decided to run a few scenarios through our Pathfinder Financial Optimisation Platform to find out. Read our findings below;

1.1 The Clients

In this example, we look at the case of David and Alice who have recently retired and who will soonboth be eligible for the age pension. David was born on 11 April 1953 while Alice was born on 15 November 1952. They have a modest $400,000 in super. Their other assets are the family home valued at $900,000 and personal assets valued at $40,000. They have no debt. They would like to have $50,000pa (increasing at CPI) for living expenses. They are worried that their super is not sufficient to maintain their desired income. Consequently, they have contemplated selling the family home and moving to a cheaper area where they could buy a new home for $500,000. Will downsizing leave them better off?

1.2 Assumptions

We have assumed in the analysis:

• Pension fund returns 5.7%pa;
• House selling costs 2.5%;
• House purchase costs 6% (including stamp duty);
• House prices in the long term increase at 3%pa;
• CPI 2.5%p.a.

1.3 Scenario 1: Retain Current Home

We first examine the scenario where David and Alice retain their current home. In this case, they will receive income from the government pension as well as drawing a pension from their own super. Figure 1 shows the sources of their income over a 20 year period.

David and Alice receive approximately 64% of their income from the age pension and associated benefits (see also Figure 6 below). The remainder is withdrawn from their pension account through withdrawing the minimum amount each year (plus some extra for the first few years until they become eligible for the age pension).

Their age pensions are limited approximately equally by the income and assets tests. After 20 years, David and Alice have a combined wealth of $1,960,000 most of which is from the family home.

1.4 Scenario 2: Downsizing Family Home in 2016/17

The next scenario sees David and Alice downsizing their family home from $900,000 to $500,000 in 2016/17. Their ages enable them to deposit the excess funds generated from the house sale into super as non-concessional contributions. However, a Pathfinder® analysis shows that increasing their superannuation balance reduces their age pension because, unlike the family home, super counts towards the age pension assets test and is deemed for the income test. Figure 2 shows the results of the age pension assets and income tests for David and Alice and we can see that their pension is now limited by the assets test. For a home owning couple, the age pension reduces at a rate of $3 per fortnight for each $1,000 of assets in excess of $575,000. This taper rate was doubled from 1 January 2017, so now has a much larger impact on the pension received.

So in 2019/20, for example, their age pension reduces from $36,337 to $9,004 and they must draw more from their pension account to make up the difference. Their wealth after 20 years is now projected at $1,581,000 or about $379,000 less than in the first scenario.

1.5 Scenario 3: Downsizing Family Home in 2027/28

In the third scenario, we examine the possibility that David and Alice defer the downsizing for ten years, say in 2027/28. Their age pension is initially unaffected until they downsize the family home, but after that time their age pension payments are severely curtailed. Their projected wealth after 20 years is now $1,714,000. This is a better outcome than in the second scenario but is still $246,000 less than if they keep their existing home.

1.6 Comparing the Scenarios

Figure 3 gives a comparison of the annual age pension received in the three scenarios. You can see that the scenario where they retain their current home, yields a higher pension and that their pension drops sharply after the sale of their house in the other two scenarios.

Figure 4 shows the total age pension payments over the 20 years. You can see that by keeping their original family home, their total pension entitlement is significantly higher than either of the downsizing options we analysed.

Figure 5 shows the total wealth over the 20 year period analysed.

The first point to note is the importance of the age pension towards retirement income, depending, of course, on the particular circumstances. Figure 6 shows the composition of retirement income over the 20 years analysed for Scenario 1.

In this example, the age pension plus estimated concession card benefits contribute about 64% to income while the account based pensions contribute about 36%. The second point is that downsizing the family home may not result in improving the overall situation as an increase in payments from a private pension may be more or less offset by a decrease in the age pension.

1.7 Pathfinder Learnings

In our Pathfinder® analysis, we find, perhaps surprisingly, that a couple could be considerably worse off by downsizing the family home. Any funds added to super by the income generated from downsizing could be dissipated by a reduction in the age pension. In addition, the costs of sale and repurchase of a family home are significant.

The age pension can provide a buffer between retirement savings and lifestyle expenses.

For persons eligible for the age pension, downsizing the family home may leave you worse off financially because of the impact of the age pension income and assets test.