To buy a rental property? Or to pay off your home loan?
Leverage is the main tool behind property investment where, in the ideal situation, you could purchase a property using money from a lender, then the rental income from the property you have purchased to help cover the mortgage and reduce debt. Over time, your mortgage size will shrink and your profits will grow, creating some sweet net wealth or passive income.
This article is all about taking the next step in your property journey. Before we begin, we want to preface that your next steps depend on your financial goals, investment strategy, and capacity for risk.
Should I pay off my own home first or my rental property?
When making the decision, take into account some considerations, tax implications, cash flow, retirement goals, and basic number crunching. Property investment is a long-term investing strategy.
Negative Cash Flow On Your Rental
If your monthly repayments from your tenants are less than your outgoings then you have a negative cash flow. This is where you are making contributions to make the investment cash neutral. In this situation, you can either look to increase the rent if it is under market value or continue with subsidising your tenant’s rent. In some cases this is a generous approach, especially if you have a good relationship with your tenants. In other cases, this is only really harming your bottom line.
Across New Zealand, rental properties are our favourite investment strategy because it’s so easy to leverage against a current home and purchase more property without a cash deposit. When looking at an investment property, you want to make sure this is in the right location to yield a positive return.
Paying off your investment property when you’re approaching retirement can be a huge relief to your monthly cash flow. However, in some cases your rental property can cover your mortgage, which is especially useful if you are looking to downsize your property, maybe from the big family home, to a small one to two bedroom unit.
If you are looking to retire within the next ten years, there is a risk of not owning the property for long enough to yield positive returns and or large capital gains. In the New Zealand property market, we know that every ten years, the house is usually worth double what you paid for it. This is a great financial position to be in and can help to fund your retirement, which is helpful because the superannuation and KiwiSaver funds may be lower than your working income.
Crunch The Numbers
What are the loan interest amounts? When making these decisions a great place to start is by looking at the loan amounts and interest rates. Maybe you have been locked in to a five-year interest rate as high as 7% and it’s up for renewal (finally!), it’s time to start paying down any debt. Getting out of this high fixed-term rate can be a great way to reallocate any extra cash.
Holding on to cash instead of paying off debt can limit the returns you receive. Using an example here, keeping your money in a bank account can result in a 2% return on investment, often at the same pace or slightly less than the rise in inflation while also paying off your home loan at a 4% interest rate. While it’s important to take into account your personal financial situation, you could look at paying off your loan quicker.
Appetite For Risk
Are you a risk taker, or are you more conservative when it comes to decision making? If you’re a risk-averse individual, you’re better off paying down the mortgage. Most people consider themselves to have a higher risk tolerance than they actually have. If you can not panic about your investment dropping by 10% or more, then your risk capacity can be higher and you can manage to invest in a riskier market.
If you currently own a home and are looking to buy a rental property, this next section is for you.
Here are some questions to ask yourself before buying a rental property.
What is your risk appetite?
As we covered just before, figuring out your capacity for risk is hugely helpful to figuring out next steps for your finances.
Paying debt has zero risks associated, and will benefit your financial position in the long-run. If you prefer to be in a zero-risk or a low-risk strategy, paying down all debts before even embarking on the investment property journey will be for you. Investing through debt is a fantastic way to utilise debt and money to your advantage, so there are pros and cons to this.
Buying an investment property means that if something goes wrong, you’re the first point of contact. Rental properties can be expensive and stressful when things go wrong, like a rent-runner or damage to the house. There’s a heap of potential to grow your wealth over a long period of time, but it takes some hard work to manage this.
You can of course employ property managers to help you out with any issues, such as negotiating rent, managing tenants, and helping find tenants.
Don’t Get Caught Up In The Hype
Interest rates have so far been some of the lowest people have seen in this lifetime and FOMO is real, especially to capitalise on the affordability of rates at the moment. But, don’t get caught up in this! Finding a good investment property takes time and can consume all of your resources. Property investment is a popular means of creating wealth, but if it’s not right for you financially or lifestyle-wise, hold off for a bit longer.
Rental properties or property investment can help you grow your wealth for the long term, so you can think bigger than right now. Keen to learn a little more? Get in touch with one of our financial advisers.