When you start thinking about buying your first home, there are myriad factors to consider. What sort of home do you need now compared with five or 10 years from now? What is the capital growth expected in the area where you are buying? What is the forecast for interest rate movements over the short to medium term? It can be a good idea to crunch the numbers for each of your options so that you can make decisions that will help you build wealth over the long term, as well as purchase the right home for your needs.
Let’s use the example of two young couples, both wanting to buy their own home and start a family in the near future. What are their options?
They could buy a small house or unit that serves their immediate needs and does not stretch them financially, and try to pay it off relatively quickly. They could potentially upgrade to a larger house later on if they want to.
Alternatively, they could purchase the largest and most expensive house they can afford right away and try to maximise capital growth, making the assumption that it will still suit their needs down the track as their family grows.
Maximising capital growth
Let’s also assume both couples have the same household income and are looking at a 10-year plan. Couple One purchases the largest home they can afford, a house valued at $750,000. Couple Two purchases a smaller home, valued at $400,000.
From the graph above, we can see that purchasing a more expensive home first should generate greater capital growth. Assuming average capital growth of 5% per annum, we can see that Couple One’s home achieved $472,000 in capital growth over the 10-year period compared with just $252,000 for Couple Two.
- Pros of a bigger purchase: If property values increase, a bigger purchase can maximise your potential profit. When interest rates are low and borrowing is cheaper and therefore less risky, it can be a good opportunity to increase your leverage and build wealth. In addition, you may not need to upgrade down the track, saving you buying and selling costs.
- Cons of a bigger purchase: There is no guarantee that your property will increase in value at this rate and if interest rates increase too much and your cash flow is already stretched, you risk struggling with the higher repayments.
The cost of debt
Both couples borrowed 80% of their property’s value and took out 30-year loans. Couple One made minimum P&I repayments ($2,530) for 30 years. Couple Two were able to afford the same repayments as Couple One ($2,530), which was well above the minimum repayment amount required for their smaller loan (i.e. they paid $1,181 extra per month).
As you can see from the graph below, after 10 years of repayments at 3% interest, Couple Two had reduced their principal by $97,890 more than Couple One. At this rate, Couple Two will pay off their loan in just 12.75 years, saving them $100,552 in interest, whereas Couple One will take 30 years to pay off their loan.
What if interest rates rise to 5%? Here’s what the figures would look like in that scenario.
In this situation, after 10 years, Couple Two will have paid $293,000 off of their debt and are almost debt free. At this rate, Couple Two will pay off their loan before the end of the eleventh year of the loan period, saving them a massive $204,475 in interest. On the other hand, Couple One will have only paid $112,000 off their debt, and still have a balance of $488,000 to pay off over the next 20 years.
- Pros of a smaller purchase: Particularly as interest rates increase, being able to pay off your mortgage as quickly as possible can result in substantial savings as well as spending less time in debt.
- Cons of a smaller purchase: If you need to upgrade to a larger home later, you will need to factor buying and selling costs into your budget. Up-front purchase costs, including stamp duty, can be roughly between $25,000 and $45,000 depending on the state you live in and how much your home is worth, and selling costs may be between $15,000 and $25,000.
- Considerations: While Couple One will have more debt after ten years, particularly as interest rates increase, they will also have more equity in their home.
These examples show there are a number of factors to consider when we look at the longer term financial advantages and disadvantages of our decisions. A great mortgage adviser can help you look at the figures involved in the various scenarios so you can make borrowing decisions that make the most financial sense for you.
DISCLAIMER: The information contained in this article is correct at the time of publishing and is subject to change. It is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, Smartline recommends that you consider whether it is appropriate for your circumstances. Smartline recommends that you seek independent legal, financial, and taxation advice before acting on any information in this article.