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Your home can end up being one of the best investments you make. Firstly, it’s probably the only tax-free investment opportunity you will ever get (i.e. nil CGT). Secondly, if you buy good quality property (home) and it appreciates in value, you can use the equity in your home to borrow money and invest it to build your asset base.
Over the past few months we have noticed more of our clients have been considering upgrading their home. Until now, this “upgrading activity” has been relatively subdued since the GFC (i.e. compared to before the GFC) – but it seems to be back in people’s minds again. There are a number of financial planning issues to consider when contemplating an upgrade which I discuss below.
Some good reasons to consider upgrading your home
There are a number of lifestyle reasons that people may consider upgrading their home including wanting larger accommodation (particularly if you have a growing family), moving closer to schools or other amenities, moving closer (or maybe further away?) to family and so on. These are lifestyle issues and how important they are will be different for everyone. However, for most people it will be important to balance out both lifestyle and financial considerations – as it’s probably not prudent to focus solely on one or the other. I just want to point out however, that this article is admittedly, unbalanced. That is, I will focus only on financial considerations and I’ll leave the lifestyle bit for you to ponder over separately.
The best financial reason for upgrading your home is to move to a property that has superior capital growth prospects. Whilst your home isn’t necessarily purchased with the goal of building your wealth, accumulating equity can certainly help a lot. Firstly, assuming your financial situation allows it, you can borrow against that equity to invest. Secondly, if you plan to move or upgrade in the future, then the more equity you have means the less you have to borrow. Therefore, having a home that has the propensity to increase in value at an average rate at or above 7% p.a. is very advantageous (which is equivalent to it doubling in value every 10 years).
When considering an upgrade have a look at your existing home’s past capital growth rate. That is, how much has it appreciated in value since you have owned it? You can use this simple Excel template calculator to work out the average compounding growth rate of your home. Remember, you are aiming for a rate of above 7% p.a.
When is the right time financially?
Typically, upgrading your home results in a larger home loan which forces people to consider the question; is now the right time to take on a higher mortgage? Is it financially safe to do so?
There are a few things to think about:
- What is the cash flow impact? How much will the higher loan amount cost you? Is it affordable based on your current budget? What if/when interest rates rise – can you afford it then?
- Do you have enough equity in your current home? What percentage of the new home’s value will you have to borrow? Is that too high?
- What is the opportunity cost of this upgrade? That is, assuming it will increase your monthly commitments, what else could you do with that extra money (e.g. invest)?
You need to consider your current cash flow position (e.g. do you have the capacity to be able to afford higher mortgage repayments) in context with any future expected financial changes (e.g. starting a family, expected pay rises, etc.). I typically advise clients to ensure that repayments are very comfortable at current rates, still comfortable at 7% p.a. and doable (albeit probably tight) at 8% p.a. If you can satisfy this then it may not be safe to upgrade. You can use our calculator below to help you assess this.
Home Upgrade Calculator
Click here to download our simple home upgrade Excel calculator. You can use this calculator to help you assess many of the above factors, including:
- If you did sell and re-buy for a different amount, how much you will need to borrow;
- How much the repayments on the new loan will cost at current and future higher interest rates; and
- Project your future equity in your home depending on the property growth rate and loan repayment amount you input. This may assist you with mapping out your future investment plans.
Don’t list it. Maybe love it?
An alternate to upgrading is to renovate your existing home. That might be an option and there are some advantages to doing this if it makes sense and if it will meet your needs. I refer you a newsletter article I wrote in July 2014 which discussed this consideration in more detail.
How to do it safely, financing -wise
Most people have heard about bridging finance – i.e. taking out a short term loan to bridge the gap between having to pay for your new home before receiving the money from selling your existing home. Most lenders will only provide bridging finance if you have already sold your existing home. If you haven’t sold your existing home yet (and I realise that more people would prefer to buy first to avoid being homeless), then there are a small number of lenders that will give you a 6 to 12 month bridging loan – but you have to have enough equity in your existing home to qualify.
With bridging finance, the bank will typically want you to sell and reduce your loan within 6 to 12 months. Therefore, one of the risks with bridging finance is; what happens if you have trouble selling your home? You may be forced to sell for a significantly lower price to meet the banks deadline.
Often we try and structure a client’s finances to allow them to avoid bridging finance and therefore not be under any compulsion to sell within a specific time period. This ensures that you have full control.
Another thing you can do to reduce your risk is to ensure you have a realistic expectation of the value of your property and its saleability/marketability (i.e. is it easy to sell? Will it sell quickly?) and base your calculations on these conservative amounts. It is far better to be conservative than too optimistic – plan for the worst and hope for the best. Speak to many local agents and we can help you do some comparable sales research via our property database.
Don’t worry about the finance bit too much as that is our job – we’ll guide you safely through the process.
Keep or sell your current home?
Our calculator assumes that you will sell your existing home which is a good way to minimise your non-deductible debt. However, from a financial planning perspective, if your home has great capital growth prospects then you might be better off holding onto it and renting it out.
Depending how your home is owned (i.e. who is on title) we may be able to restructure your debt to minimise the non-tax deductible portion which we are able to investigate and advise on, where appropriate. An article I wrote for Australian Property Investor magazine back in 2005 (where did that decade go? Seriously!!) discusses this in detail – click here to download.
It is important to divorce emotion from this decision. Most people have an emotional attachment to their home, think it’s such a great property and consequently think it would make a great investment. However, often, that is not the case. Remember, when we buy a home we rarely buy it with an investment mindset.
If your existing home makes a perfect investment that ticks all the boxes, keep it. If it doesn’t tick every box then you are probably best selling it and borrowing less. You can always buy a pure investment property in the future.
We have lots of experience with this
Hopefully this blog has given you a taste of the issues that you need to think about when considering upgrading your home. Of course, everyone’s situation is different so if you would like to chat about your particular situation, please don’t hesitate to reach out to us.
