Monthly Archives: June 2014

Financing

#5 What mortgage payments can I comfortably afford?

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So with $100,000 we can afford to buy a $400,000 property. But can we make the mortgage payments? Looking at a home loan comparison rate finder on the internet I can see the lowest three year fixed rate home loan rate is currently 4.69% (June 2014), which would make our monthly payments $1,250.  But can we afford this?

Regardless of how much the financial provider will lend you, you need to do your own calculations to work out realistically and comfortably how much you can borrow. I remember when I was asking for mortgage pre-approval five years ago the bank was willing to lend me close to $1million!! Believe me, I could NOT have afforded this AND been able to buy bread and milk each week!

FIRSTLY you need to work out your income and expenses. The simplest way to do this is get all of your bank and credit card statements for the last 3-6 months and identify all of your (and partner’s if relevant) net income (post tax and super) and expenses. Being the geek I am I like to put this in a spreadsheet & categorise it. Remove any non-recurring items but make sure you include big annual expenses such as holidays and insurance policies and income such as bonuses. If the property will be your new home, deduct any rent or mortgage payments as these will not continue. Let’s assume we’re doing this analysis for a monthly basis.

Income:
$ 3,750           Salary (net after tax & super)
$      50           Share dividends
$    300           Interest
$ 4,100          Total Income

Expenses:
$    300           Utilities
$    350           Food (at home)
$    500           Entertainment: eating out, alcohol, movies, etc
$    150           Mobile phone, travel to work, magazines
$    400           Car payments, petrol, servicing, insurance, etc
$    300           Clothes
$    300           Holidays
$    400           Insurance: home & contents, health, etc
$    200           Personal care
$    100          Gifts
$ 3,000          Total Expenses

Net income per average month $1,100

This exercise is very simple if a bit tedious, but unbelievably eye-opening too. If you categorise your expenses and calculate the percentage of each category against the total, sometimes you might be frightened how much you spend on gifts, going out, travel etc. It’s also a good exercise to do if you want to save money.

SECONDLY you need to forecast your short to medium term financial position. Consider the timeframe that you would consider fixing the mortgage for (typically 3-5 years). This is incredibly important because if your circumstances change, you need to still be able to comfortably pay the mortgage. Some things to consider…

  • Income increasing – For example, if you have your own business and it is in the growth phase, or you expect a pay increase from work. This is a tricky one and being the conservative I am, tend to approach this type of forecasting with caution,
  • Income decreasing – For example, what are the chances of being made redundant? Is there a seasonal downturn in your earnings? Will one of you be going on maternity/paternity leave soon?,
  • Expenses increasing – For example, will I start having children, or for those parents out there, another child? Are you buying a new car? Going to start studying again?,
  • Expenses decreasing – For example, will repayment of HECS debt or any other loans or credit cards be ending soon?

Adjust your average monthly income and expenses for these future events and you end up with the net amount available to pay a mortgage. If you also want to save money in addition to paying your mortgage then adjust this further.

LASTLY, using a simple calculation we can work out the mortgage payments you can comfortably make each month:     (monthly net income X 12 mths)  /   annual mortgage rate %

In this example:                                                                                        (1,100 X 12)    /    4.69%     = $281,000 mortgage

Therefore this tells us that even though we have saved $100,000 (well done!!) and we can afford to buy a $400,000 property (with a $320,000 mortgage), we actually can only afford a $281,000 mortgage. So using our LVR of 80% this means we can only really afford a $350,000 property. Again, by thinking “well I’m ready to go with my $100,000, that’s my 20% deposit for a $500,000 property”, you not only need to look at the total CASH OUTLAY when buying a property but also your NET INCOME to see what mortgage you can really afford.

Up next… 3. What is my risk appetite regarding fixed versus variable mortgages?

Financing

#4 How much cash and/or liquid assets do I currently have?

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When we’re thinking of buying a property sometimes we can focus on just the amount required for the deposit. But there is a lot more to paying for a property than that.

What is “cash”?

  • The money you have in your wallet, which isn’t going to get you far when buying a property so you can exclude this (!),
  • The net CREDIT balance in all of your bank accounts. For instance you may have a transaction account, which your salary gets paid into, you pay bills from, have an ATM card and draw cash out of. You may also have a savings account, and
  • The balance in a term deposit that is not locked in for a fixed period of time, i.e. a high interest earning account such as an ING account or similar.

What are “liquid assets”. In this case liquidity has nothing to do with a state of matter such as water, but instead refers to how easily an asset is converted to cash.

  • The simplest example is shares, which are traded on a stock exchange and can be sold for cash as quickly as you can call your broker, and
  • A term deposit locked in for a fixed period of time that is either maturing soon or the contract can be broken early for a penalty fee.

So go ahead and add up all of the cash and liquid assets you have and then let me tell you how that hard earned money will be spent when you buy a property…

1. Firstly you need a deposit. Nowadays financial providers will tend to lend you up to an 80% LVR, but sometimes 90% if you take out Mortgage Insurance (MI) and/or have a guarantor. But beware, MI is very expensive.

I would like to quickly explain how MI works. Going back to our $500,000 property, if you only have a $50,000 deposit your mortgage provider can charge you insurance in the event you default on your repayments. On a mortgage of $450,000 you could pay around $8,820 of insurance (about 2% of the loan).

You can either pay the MI upfront (which means you need $58,820) or add it into your mortgage, which may seem like a good idea as the additional monthly payments aren’t that much (for e.g. $67/month) but you end up paying interest on the MI and over the life of a 30 year mortgage you could pay almost three times the amount of insurance!

2. Next we have lots of purchasing costs that can really add up: lawyers or conveyancers fees, property search fees, building and pest inspections, mortgage and associated fees etc. I would budget for another $5-10k on top of your deposit, and more so if you do this for a number of properties you try to buy along the way.

3. Then comes the big hitter, Stamp Duty. Stamp Duty is charged on the value of the property by the state government for transferring the property from one owner to another. Stamp Duty varies from state to state, generally increases in proportion with the value of the property and concessions may be given for first homeowners. Using our example of the $500,000 property and lets say we’re in NSW, the stamp duty would be almost $18,000, or 3.6%.

4. And then finally, after the deposit, stamp duty and purchasing costs, do you have any more money left over? What you can do with this will be discussed in later posts.

In summary, to buy a $500,000 property, we need to have $128,000:                                                                               $100,000       20% deposit                                                                     $  10,000        purchasing costs                                                           $  18,000        stamp duty                                                           $128,000

 

If I had $100,000 and thought to myself, “well I’m ready to go, that’s my 20% deposit for a $500,000 property”, in actual fact I can only afford to buy a $400,000 property:                                   $  80,000        20% deposit                                                                     $   7,000        purchasing costs (assuming we economise)           $ 13,500        stamp duty                                                          $100,500

 

This analysis tells us what value property we can buy, but it does not tell us what value property we can afford to pay mortgage repayments on.

Coming soon… 2. What mortgage payments can I comfortably afford?

Financing

#3 How much money can I and should I borrow? Structuring your mortgage and lessons from the GFC.

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Structuring your mortgage is, in my opinion, the most important decision with regards to property. Not “what sort of property are we going to buy?”, “where are we going to buy?”, “I really like wooden floorboards, picture rails and open plan kitchens…”. None of that matters until you work out how much you can borrow and how you are going to make that mortgage work for you.

Unless you can pay in cash, all of us mere mortals will require a loan to buy property. And structuring your mortgage does not just apply to when you first buy a property. When your mortgage matures you should revisit this process again because chances are, your circumstances are very different from when you bought 3, 5, or 20 years before.

There are a few key questions you need to ask yourself –

  1. How much cash and/or liquid assets do I currently have?
  2. What mortgage payments can I comfortably afford?
  3. What is my risk appetite regarding fixed versus variable mortgages?
  4. Will this property be a home or an investment, now and in the future?

I will delve into each of these questions in detail in following posts but in a nutshell what we are trying to establish is how much can you afford to borrow and therefore what value property can you buy, in addition to how you borrow that money. And it all comes down to thorough analysis, planning and understanding your risk appetite.

Does this all sound like gobbledy gook? I promise if you keep reading, all of the mysteries of mortgages will be explained plainly and simply and you’ll be quoting the latest variable interest rates in no time!

So, back to risk. Risk is all about how much you like living life dangerously, and in this case with regards to debt. Wild! If you are risk averse you buy a modest family home that does not stretch you financially and you work hard to pay down the mortgage as soon as you can so that your debt is minimised. An admirable and respected approach that probably a few more people should take. If you are a risk seeker you may stretch yourself to your financial limit to buy multiple investment properties with a lot of debt in the hope you can make a quick buck and sell them on with a good profit in a short period of time. Also perfectly acceptable, provided you have done thorough research.

Which leads me onto the Global Financial Crisis (GFC) – which hit the world in late 2007 with its effects still reverberating today. Economies have experienced many an upturn and downturn, with some saying cycles tend to last approximately 10 years, but due to business’ increasingly borderless and global nature, the recent downturn has had the furthest reaching effects worldwide and on a scale not seen before.

So how does the GFC affect us normal people with mortgages, jobs and the daily grind? Breaking it down in simple terms, it’s all about not being able to pay your mortgage when the going gets tough.

During the early 2000’s property values were increasing steadily year on year. Some would say owning property was a license to print money. Financial lenders cottoned onto this trend and started offering bigger and bigger mortgages and at Loan-to-Value ratios (LVRs) of up to 110%. An LVR of 110% is where you don’t need a deposit or any further savings to pay for initial costs such as solicitor’s fees, taxes and duties. So for a house worth $500,000 you could get a loan for $550,000 with absolutely no savings to your name. Sounds crazy, doesn’t it?

The financial services industry then did some crazy stuff on a large scale with these fairly risky and sometimes not very secure mortgages by trying to sell them on as A grade premium on the basis that property prices would just keep going up. After a while people started to realise these mortgages weren’t quite what they seemed and the house of cards came tumbling down.

Over time property values started plateauing and then decreasing and a combination of two things happened: (1) the economy was negatively affected by property values declining and people started losing their jobs and therefore were unable to pay their mortgages, and (2) the value of a property no longer covered the value of the mortgage and financial lenders started pulling back on lending, which made getting a mortgage more difficult and so less people were buying these houses that the people who lost their jobs now couldn’t pay for. What a snowball effect!

The lessons to be learnt from this latest financial crisis are that property values do not always increase, and that we should not borrow more than we can afford, regardless of what the bank is willing to lend. And importantly that this is one of many financial crises that have occurred and will occur again. Property, and the economy in general, is cyclical – there are always periods of incline followed by periods of decline. So let’s buy that property, be it grand or modest, a family home or a fixer-upper, and let’s stretch ourselves only to the point where if the world went into crisis again, we wont be caught with our proverbial pants down.

Stay tuned for question number 1. How much cash and/or liquid assets do I currently have?