The interest-only way
Stevie Waring explains why a debt-free couple in their 50s took on an interest-only loan for their first investment properties.
30 April 2023
A couple of debt-free homeowners were in their early 50s when they bought their first investment properties, worth $2 million.
But even though they had no personal mortgage, Opes Property partner Stevie Waring suggested they take out an interest-only loan. So, how would this benefit our mortgage-free, first time investors? Here’s how it worked.
Auckland couple Joan and John describe themselves as “relatively conservative”. They were in their early 50s, had paid off the mortgage on their own home, but had never invested. However, they had received a large inheritance of $1 million and wanted to use the money wisely.
HOW MUCH MONEY?
To create a property investment plan you first need to figure out what you’re investing for. In other words: “How much money do you need to make your goal a reality?”
Joan and John said they wanted a passive income of $120,000 for when they retire in 15 (or so) years. They chose our Golden Goose strategy, which is when you build up a growth portfolio, sell them for high yielding properties, and live off the income forever.
Joan and John were in pretty good financial shape already. As well as a $1 million inheritance, they both had $200,000 KiwiSaver accounts and earned just shy of $100,000 each.
This meant if Joan and John did absolutely nothing else, they were on track to reach $70,000 of their goal. I should say that, in all my calculations I leave government superannuation out. Why? Because even though adding it in would blow Joan and John right past their goal, we don’t want to have to count on it.
At Opes we call the gap between your retirement goal and what you’re on track to achieve a Wealth Gap. One way to close a Wealth Gap is to build an asset base, which is a fancy way of saying fill it with properties. It was time to go shopping. But John and Joan were unique, because they had no personal mortgage. This is what lead to the big question: should the couple use an interest-only loan?
If Joan and John bought two investment properties at $940,000 and $1 million (and those each gained 6 per cent growth) they’d get to 96 per cent of their goal. (Yes, this is 4 per cent short, but I’ll get to that in a minute.) With their inheritance, they chose to put a 30 per cent deposit into each – 10 per cent extra than required.
They did this for two reasons:
1) It makes these investment properties unencumbered from their own house.
2) It makes the cash flow manageable.
But remember, we weren’t quite at 100 per cent of their goal. This is where I started talking to them about an interest-only loan solution.
Property investors love an interest-only loan. In fact, almost half of investors use them because it frees up cash flow in the short term to concentrate on paying down personal mortgage debt.
But interest-only loans, while cheaper in the short term, are much more expensive over their lifetime. So, why was I suggesting this to newbie investors, Joan and John?
Well, on an interest-only loan, these two properties are giving around a 340 per cent return on investment each.
There is a $225 top-up Joan and John have to pay from their own pocket to hold on to the property. But this contribution will only hang around for about three years. After that the property will become positively geared and the rent will cover all expenses.
Now, let’s look at these numbers if we change these loans to principal and interest (over a 30-year term).
The contributions need to continue for eight years, and the ROI drops slightly to 300 per cent. So for every dollar you invest you get $3 back, instead of $3.40. The cash flow is so much worse when you’re not interest-only.
Joan and John will have paid off about $300,000 of debt on the two properties (over the next 15 years) but it’s probably not going to change their life. A better use of their money is to buy another property. Hear me out.
In three years time, the two Auckland properties will be able to fund the contributions of a third property, once they become positively geared. At 6 per cent growth, another $1 million Auckland property will get them to 124 per cent of their goal; $186,000 passive income, in a 15-year time frame.
If they want to just stick to $150,000, they can retire three years early. Either way, the impact to Joan and John’s retirement is significant. Either they earn an extra $36,000 in passive income, or they retire three years earlier. All thanks to the interest-only loan. If these guys had a mortgage, I’d be getting them to pay down that personal debt as fast as possible. But in this instance it made more sense to free up cash flow to grow their portfolio faster. If you want the same results, your next step is to book a Portfolio Planning Session with Opes Partners.