By Elizabeth Kerr
This week I’m talking to you about one of the many stupid things that the middle squeeze do to stay poor – Buying up.
The decisions you make around your home are one of the biggest determinations for achieving any kind of financial independence for yourself.
If home ownership is your game, then the sooner you can pay off your mortgage, the sooner you will have some power for your personal money machine.
You loose this power every time you buy upwards. Buying up means willingly buying a house that is more expensive than the one you currently own.
As an example there was an interesting segment on "Sunday" a few weeks ago about a couple who brought a home in Avondale for $345,000 and sold it 5 years later for $650,000.
That was a great outcome for them - a $305,000 tax free gain.
However they went and spent that money on a bigger home boasting that the gains they made on the sale in Avondale kept their mortgage repayments the same as they were used to. Doh!!
Right then they had an opportunity to make a very big life changing financial decision and they wasted it because they felt they were "running out of space" and wanted a "bigger house".
If I could have stopped the show and re-wrote the rest of the story I would taken the proceeds from the sale of their home and brought a cheaper home than the one they sold, allowing the remainder from the sale to be deposited into their money machine.
Instead they recommitted themselves to another round of mortgage payments further delaying their financial independence and significantly reducing the amount of money their machine will ever be able to produce for them.
Using your home as a money making tool is a really simple idea but the social pressure to keep 'buying up' keeps people from really utilising their number one asset to their advantage.
Buying up is a really common middle squeeze thing to do.
Following significant doses of reality tv and peer pressure they just must have guest rooms, more bathrooms, a two car garage, a place for the kids to play out of earshot, a butlers pantry and a private school zone.
The problem is all this requires going further into debt to afford it.
Without sitting down and working the numbers what they don’t realise is that decision is the maker of them financially over the coming decades. Just because they are given the mortgage to afford it over 25 years doesn’t mean they should do it. Chances are they will be paying for that larger house when it’s just the two of them bumping around long after the kids have left the roost.
It would be much smarter to get rid of the mortgage and use the extra money to fill up their money machine or sell down and moved to a better house in a cheaper suburb, whilst putting any surplus money from the sale into their money machine.
(Some people are forced to buy up because of a change of circumstance such as work relocation or leaky buildings. Those sorts of situations require different strategies to get a good money outcome; I’m talking today to those who buy up just because they want to).
“But it’s for the kids…”
Kids are often touted as the crutch for moving to a bigger house. “Sophie needs her own room”, “The boys are too old to share now”, “we want them to go to such and such school so we need to get in zone”.
If this sounds like you then stop and really think about it using numbers instead of emotions.
Kids are only with us for such a short time in the scheme of our entire life.
The amount of time that your family home will feel too small is actually only a few precious years between one leaving home and the other finishing school. And there are some real benefits to being in each others presence. The close proximity of each other means you will know if they are doing drugs, their homework or organising to get up to trouble.
They will also by default come to appreciate their own space and possessions and they might even come to politely respect yours as well.
After all we all managed to grow up in homes far smaller than the average being built now and we’re not emotionally scared as a result. I’ve never met anyone who has attributed their failures in life to having shared a room as a teenager.
As for the school zone issue - The "zone" that your kids need to be in is a home environment that is relaxed and confident and that is something that being money smart does. Kids need parents who can be present and not working themselves to a financial stress induced depression or divorce to pay for things that they don’t really need.
That "zone' will be the best predictor for your child’s success regardless of what school they attend.
Still lost?
If you’ve made it this far and you’re still not sure what I’m talking about let me break it down for you. This is important stuff here!
Chances are you brought a home and took out a mortgage to pay for it. Over time, all things going well, your house will increase in value and you will be paying down the mortgage. If your house is located in a desirable area with good proximity to the things people like live around - schools, shops, café’s, parks etc. ... then chances are the demand for people wanting to buy in that area will go up, and they may be prepared to pay more for your house than what you originally paid for it.
This difference is referred to as a capital gain - thet is, the amount that you can sell your house for over and above what you paid for it.
Where people go wrong is when they trade their capital gain in for a new home that costs more to own than the current one does. That is, they “buy up”.
The kiwi dream?
It seems that in New Zealand owning a large home is a symbol of your success. The very rich have large homes and envy is what makes the world go around, so being able to cash in the current house and remortgage for a McMansion is just one step closer to being successful right?
The houses being built these days are some of the biggest houses we have ever seen and begs the question – is all that space even necessary? They dwarf their 10 cent piece sized block, competing against their neighbour’s cookie cutter replicas and are so big with their multiple open plan living areas, home office, double garages and a selection of bathrooms that the only time for bothering each other is when passing through the front door.
In my opinion a large home is a canvass for having to acquire more stuff just to fill each room to the brochure style you’ve come to expect.
You can’t argue with maths and numbers.
Numbers don’t lie, they don’t manipulate, they are completely unemotional, and they just are what they are. However it never ceases to amaze me how distorted people can become about their own numbers.
How much they really earn, how long they think it will take to pay off their home, how much money they need for retirement or how far they think they can stretch the pension. These things are definite, but ask someone to tell you about their home in numbers and chances are they have no idea. If they did they would probably be smarter about their house purchasing choices.
When you break it down into numbers it just seems so ridiculous to me that someone would want to go to work to pay for extra room which just holds stuff and things – a couch, a bed for guests, an ab-rocker, boxes of old toys and a cupboard full of empty suitcases used barely once a year; or an extra bathroom for which you will sit and stink just the same.
Extra space in my opinion is not worth getting up 5 days a week for an extra 20 years to pay for, regardless of how smelly your teenagers can get. Your car is not going to hug you for parking it in a bigger garage, it doesn’t care.
Harness the benefits now
Downsizing your home (or just staying put) is often associated with those oldies who are preparing for their final hurrah, as opposed to young families or people in the prime of their working lives.
But given our soaring property prices at the moment I think it’s a perfect time to start harnessing some of these savings in real terms.
Selling your home and moving to a cheaper one brings the following benefits:
1. A debt free home allowing for what used to be trapped as mortgage payment money to be saved and gain compounding interest in your money machine.
2. Regardless of where we sit on the capital gains tax issue – there currently isn’t any so this is a great time to secure a tax free chunk of cash to invest.
3. Smaller homes in cheaper suburbs usually cost less in council rates.
4. You will have less house maintenance to do with a smaller house. It doesn’t take as long to wash the windows and clean out the gutters.
5. And in some areas the demand for your home is so high you might get more money for selling it than you ever predicted.
Now I’m not advocating you run out and buy a new house unless moving was on your list of things to do already. I’m just trying to advocate to NOT become trapped by the social pressure to buy up. Bricks and mortar will not make you significantly happier over the long term but being money confident will. The extra space is not worth the financial expense and the opportunity cost to your lifestyle.
Time is your greatest asset when it comes to wealth and if you’re spending it upgrading your home you will have nothing to show for it accept a breezy caravan on blocks and shame on you if something goes wrong in the meantime and your luck runs out.
This isn’t the end that you will hear of on things to do with housing from me.
The numbers that surround your home can be the maker of your financial independence.
Try to keep your emotions out of it. Keep it simple!
24 Comments
A numerical example:
Buy a house for $400k with a $300k mortgage. Several years later it is worth $800k and the mortgage has reduced to $200k giving you $600k in equity.
Typical action is to buy a house for $1m using the equity from the previous one, leaving you with a $400k mortgage. At 6% over 20 years, this mortgage will cost you $687,773 in payments.
Alternative action is to buy a house for cash. Buy one for $600k and you will save the $687,773. Buy one one for $400k, invest the $200k at 7%pa (average real stockmarket return) and you will make a further $773,936 over 20 years plus the $687,773 making $1,461,710. At a safe withdrawal rate of 4%, this will pay $58,468 in perpetuity from that point.
Total return has always gone up over a 20 year period - see http://www.businessinsider.com.au/range-of-annualized-stock-bond-return…
Sure, there is always a risk that you may pick the only 20 year period in history wen this happens but this is also true for house prices.
In terms of costs, I have assumed all costs are equal for simplicity. As Elizabeth points out, in practice, a smaller house has less costs so my figures are a low end estimate.
Agree 100% Elizabeth. You could go even further and quantify how many hours/ weeks/ years of extra work is required for each 'must have' feature.
eg that extra bedroom which adds $40k to your mortgage probably represents several years savings. Worth it?
Now that summer is coming up you may want to do an article on the economics of owning a holiday home - total costs in rates, insurance,lawns, paint etc etc........divided by the number of nights used. I speak from experience.
And what do you need that extra bedroom for? I know my parents used that extra bedroom as a "spare room in case guests come over".
So basically paying a mortgage on a room so that guests can stay for free - instead of not having the room and guests can pay for their own hotel.
We did exactly that Elizabeth, sold our Auckland central suburb bungalow but instead of moving to a smaller provincial city, we hopped across to Brisbane. We now have a home which is way bigger than our Auckland home with a nice pool, just as close to the CBD at 2/3 the price. Brisbane has similar feel to Auckland but with lower cost of living, way way lower council rates and more superior public transport. Downside, no beach nearby and it gets bloody hot in summer. My salary here is almost exactly the same as Auckland (same amount in AUD as in NZD) but I have more spare until the next pay.
Perhaps are some other reasons why people might choose to lever up with debt/property, and not have cash.
1. Prices are skyrocketing in Auckland mainly because of ZIRP, NIRP carry trading foreign money. Consider that in Germany you can get a 10 year loan fixed at less than 2%. All that low interest money looks for a home which it finds in Auckland property. Unless there’s a catastrophe that trend looks like it will continue. So that pushes prices higher.
2. Our dollar is historically high, perhaps because were standing on the side-lines of a titanic currency war. Whatever the reason, when the NZD goes down it’ll just encourages the carry traders even more, and that will pump asset prices even higher.
3. Its obvious that the National government is deliberately doing nothing about the foreign money influx into property. But worse, national has opened the immigration flood gates to pump property even higher! Incidentally that foreign money is turning kiwis into tenants in their own country and eviscerating the middle class and elderly fixed incomers. Oh well, that pushes prices higher.
4. It should be crystal clear that the OBR and covered bonds mean that your money is unsafe in the bank. If your money doesn’t get obliterated by inflation , it will get confiscated during the next banking crisis. People must be weighing this up which pushes asset prices higher.
5. Annual Auckland house price inflation by far and away exceeds most peoples annual income. In some cases by staggering amounts. This puts tremendous pressure on people to lever up to the max and buy property.
Agree with the main sentiment of the article - don't buy more house than you need. A great example is Garth Barfoot, director of Auckland real estate company Barfoot and Thompson who has lived at the same house for the last 45 years. Warren Buffett, too, has lived at the same house for a long time.
But these guys presumably live in relatively nice places to begin with. Sometimes, if your street or neighbourhood sucks, (crime, lots of rentals and transient residents, too many parties, etc.) you just have to move. And maybe you wouldn't be happy spending the rest of your life in that tiny first home in the outskirts that you was all you could afford 10 or 15 years ago. If the sums work out, then by all means trade up. The point is to do the sums beforehand and know what you're getting yourself into.
I do not agree with the suggestion to move to a cheaper suburb to free up cash (unless there is no other option). Knowing your neighbours and living in a good neighbourhood are a major factors in having good quality of life. Perhaps trade down in house size, if the extra bedrooms aren't needed any more. But stay in a good area.
The references annoy me, you do not buy a house, you buy a property with buildings/improvements, if you live in it it will be your home. Treatment of this as anything other than purchasing the provision shelter for you and your family is just speculative. You may trumpet capital gain but if you aim to exchange it for a property which is equivalent but located/laid out differently to better suit your needs their values will be much the same.
A progressive approach can be wise to keep overall borrowing to a minimum. When beginning a family 1 bedroom will do for some time, maybe 3 years. Then it is easy to get 3 kids of any sex, into 1 additional bedroom until the oldest is are almost 10. FHB's should not need a 3 bedroom house until they need to split boys and girls shared at this age.
All the time have a portion fixed and a portion floating that can be paid down with discipline.
When the kids start to leave, adjust accordingly.
A well written article with one major flaw. The point is you never truly own your own house until that last payment is made. So anything in between means nothing. What i mean is if you trade up large and can afford the mortgage then do it. As eventually when you hit 55 you will trade down again and guess what your mortgage was never paid off. The point is, live in a house you can afford and dont worry about the mortgage. Because if you did not own a house you'd be paying rent anyway to a similar value each month be it a 1 bedroom (newly wed) or for 4 bedroom (3 kids and a room for Mum!). Do you get my logic? A mortgage means nothing as you can always sell up and usually a more expensive house will lever you more money in the long run than a smaller house so you are better off in a bigger house (that you can afford)
What if you dont want to wait until 55? What happens if you want to voluntarily take your "long run" away? I get your logic but the factors for making it a successful transition are reliant on stress free and secure employment that provides an ever increasing income and a rising property market. Both of those things are not available to everyone. Ownership has to come into play eventually and I argue that voluntarily sooner is better than later.
The principle of this article I understand and it’s the same one as your previous post, i.e. as your earnings wealth increases, don’t let your demands increase with it……..BUT scaling down whilst secures wealth in the short term, reduces it in the longer term as (all other things equal) the larger house/more debt provides more leverage, hence when it increases in value (over long periods it will), it will increase much faster than the unleveraged smaller asset + the bank deposits. This is why scaling down is mainly a retirement thing, you take the money then when you need it instead of keep building wealth………………………………………………………………………………………………….. Will we see any posts in the future where one doesn’t have to give everything up, post doing well? Where wealth and well-being is exciting, innovative and will collectively create a high wage economy rather than batting safe and sitting on our eggs?
I dont want people to feel like they are giving up anything. But that is more a state of mind as there will always be more one could strive for. People who do "sit on their eggs" and take early retirement would likely argue that they gain far more than they give up. The answer to your question may just be another question - when is enough enough?
Hmmmm.... This is making my head swell a little. If I sold my Auckland rental property it would mean that we live in a mortgage free house here in Tauranga. Are you implying that the better strategy would be to do this and invest the surplus funds (funds that were previously going on the mortgage) into managed funds? This option doesn't seem to sit that well with me when I think of the capital gains I have made of the recent years.
I want to just mention here that home ownership and property investment should not be intertwined when interpreting my article. Any conversations about leverage and maximising capital gains are worthy conversations when discussing property investment and the current market but i think that where you hang your hat should be approached with different measures.
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