By Victor Yan and Louis Portail
Last week we at UNIT had published “Introduction to Property Investing” as the latest in the club’s personal finance series – detailing important concepts such as how property instruments derive their returns, types of property instruments, as well as historical risk to return profiles.
While part of personal finance is heavily focused on capturing market returns via a selection of financial instruments, it is also inclusive of the large financial decisions we make during our lifetimes. As the “Australian Dream” dictates, it is the goal of any and every Australian to one day own his or her own property. As such, we at UNIT thought it helpful to write an extension piece to property investing – drawing a logical framework towards whether one should buy or mortgage their future property.
Before jumping the gun and buying the next property on the market, it is important to consider whether the prospect is reasonable after detailed consideration of one’s life and financial circumstances.
For one, there are different reasons for looking into the property market, whether for the purposes of raising a family or for seeking pure profit from investment, and any combination of these extremes bridging this broad spectrum.
For those who have done the second-level Finance core Corporate Financial Decision Making (CFDM) at the University of Melbourne, this is akin to the decision to invest, where one rationally decides to invest given a positive NPV (Net Present Value, or, the future value at the present time) conclusion. For the pure property investor seeking financial gain, NPV would be determined based on hard cash flow numbers and the like. For the pure house buyer, NPV could abstractly be computed by the utility of having a roof upon one’s head, a residence to raise one’s family in, or simply a place to call home.
Once decided on the reason for one’s ambitions into the property market, we can explore the general two ways of procuring property: Buying the property or mortgaging the property.
Here, buying means a lump sum payment in cash for the property selling price at the time of purchasing, while mortgaging typically involves a down payment of around 20% of the house value where the excess is covered by a lender, and principal and interest are paid off over the course of the mortgage to the lender.
Borrowing again from the CFDM analogy, this is similar to the decision of buying or financing, where one compares the NPV values derived from a buy decision and finance decision, and chooses the option yielding the higher positive value.
Financial theory aside, there is no “universally right answer” towards buying or mortgaging the house. Instead, there are compelling arguments for going down either path, and these should be filtered against your own personal and financial circumstances. In this, we will represent a scenario where one might be more inclined to buy property outright, and a latter scenario where mortgaging may appear a more attractive option.
Scenario A: BUYING THE PROPERTY
Imagine I was making a decision to buy or mortgage for a property. My current financial circumstances detail that I am relatively debt-free and that along with decent savings, I work a good paying job. As property is a large investment, this may provide reason to buy considering I have some safety margin in funds in case of a property market downturn.
Moreover, I have capital diversified into other investments such as stocks and bonds. As with portfolio theory, this diversification may signal a good justification to buy a house, as this ensures I wouldn’t over-leverage investment risk purely into property.
I’m quite urgent in trying to find and negotiate a good buying price for a property, and also want the benefit of finding it at a good price. If you emphasize on these characteristics, buying a house is typically faster than the bureaucratic process of negotiating mortgage loans. Additionally, payment of cash consideration in the perspective of the property seller is always more enticing, as it provides upfront guarantee without the seller having to bear the risk of accepting to sell to a bidder planning to mortgage, only for that bidder to be denied mortgaging down the line causing the sale to be voided. As compensation, you can usually get a better bargain price for your property purchasing price.
As with my time horizon, suppose I prefer a more long term investment attitude rather than one of a short term trader. With this in mind, buying a house and selling for profit after an elongated time period can allow me to spread my fixed costs at time of purchasing (ie. Lawyer costs, inspection costs) and at time of selling (ie. Closing costs). Additionally, this longer time horizon gives me justification to depreciate my house reasonably over a greater span, where this depreciation is tax-deductible from my yearly income statement.
Finally, I might be an investor who appreciates choice flexibility and freedom. This is another potential argument for buying outright, as by doing so, you claim complete ownership of the house. Unlike a mortgage, I don’t have to abide by any lender restrictions. I can refurbish or renovate my property to my liking, and also have no obligation for costs such as an appraisal payment or homeowner’s insurance.
Scenario B: MORTGAGING THE PROPERTY
In this scenario, I have a job with stable income but do not possess enough spare capital to buy the property outright. So, I may look to procure this investment via a mortgage by affording a down payment to a lender, and thus am obligated to pay principal and interest down my outstanding loan typically every month. (However, I can write-off these interest payments from my taxable income). This is typically the biggest reason for mortgaging as it is not often the case that investors have spare capital lying around enough to outright purchase the property itself.
However, for an investor with spare funds available, there may be an argument for mortgaging anyways, and that lies within opportunity cost (the next best alternative for allocation of your resources). For example, I could
- Buy a property for $100,000 or,
- Mortgage by placing a 20% down payment (ie. 20%*$100,000=$20,000) at an interest rate (let’s say of 5%).
Here, if I believe that the property value will not increase in the future, and that by mortgaging rather than buying, I free up $100,000-$20,000=$80,000 to be allocated to other investments, this could give me a greater return relative to the interest rate paid out of 5%. In this scenario, my return from using my spare funds to invest in other instruments can have higher returns above the interest costs involved in mortgaging. Relative to a property that isn’t expected to appreciate in value, mortgaging looks attractive in its return profile over buying the property.
This “opportunity cost” argument is even more compelling if I’m mortgaging the property in a low interest rate and/or high inflation environment. Here, low interest rates given that the returns on my alternative investments are unchanged – result in a greater net gain of returns, thereby increasing net returns. Additionally, a high inflation environment effectively erodes the “real value” of my outstanding loan repayments, thus meaning cheaper payments I’m obligated towards my lender.
If my risk tolerance is on the higher side, mortgaging might appeal to me due to its leveraging characteristics. As learnt in financial theory, leverage facilitated by borrowing activities inherently increases your risk exposure, but also increases your expected return profile.
For example, if you bought a $300,000 property would rise by $400,000 over its investment lifetime and is thus now worth $700,000 as a buying decision, your return would be 700,000/300,000 = 2.33 = 233%.
However, if you had mortgaged by putting a 20% down payment of $60,000 (ie. 20%*$300,000=$60,000) and borrowed the remaining 80% in the same scenario while paying a 5% p.a mortgage, plugging this scenario into a mortgage calculator will see you repay a total of $463,814 in loans.
Thus, the same $400,000 gain on the property value would see you achieve a return of (700,000-463,814)/60,000= 3.94 = 394%, hence illustrating the higher return potential via a mortgage pathway
(Note: There is a breakeven point for leveraging if the property does not appreciate by a sufficient extent to cover the mortgage payments, leveraging will lead to lower relative gains than buying outright).
Finally, as with all aspects of investing, it is admirable to aim for financial discipline, of which taking out a mortgage can help provide a good yardstick test towards. As noted, mortgaging requires payment of interest and principal over the course of the loan, which will require you to develop a steady habit of savings for each month in order to fulfil these financial obligations. While forced savings can be viewed upon as an added layer of stress, it can also offer growth in your capability to cultivate the right financial habits applicable to your holistic investing profile.
In summary, a few dot point considerations towards buying vs mortgaging:
- Do you have enough spare funds to purchase the property or would you need to borrow funds to cover the excess costs?
- Are you well diversified in other forms of investments?
- Would you rather have your tax write-off sourced from the depreciation of the property (ie. Buying) or the interest payments to the lender (ie. Mortgage)?
- Am I an investor with a short term or long term time horizon for my property?
- Am I an investor emphasizing on urgency to acquire property? Do I value the freedom and flexibility to operate my property as I see fit?
- What is your level of risk tolerance (Mortgaging involves leverage on your property)?
- What are the opportunity costs of buying instead of mortgaging? Can you allocate spare capital from a mortgage decision into other more profitable investments?
- What is the current inflation and/or interest rate environment? Are those aligned with an opportune time to get a mortgage?
To conclude, making perhaps the largest financial investment of your life should be treated equally by a large deal of detailed thought and consideration. While it isn’t essential to become the next “property-investing” guru, it is important to be wary of these essential considerations and figure out how they fit in with your current circumstances and future ambitions.
We at UNIT recognize that although our main audience pertains to a university cohort without the funds or need to acquire property as of this moment, we encourage a proactive approach to personal finance and hope that readers of this piece can be appropriately informed when they do get to that next stage in life of owning a property.
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.