The largest progress to financial independence is made through cutting wasteful spending and being more in control of our money.
Then investing this surplus cash to create many more future dollars.
But what about costs that aren’t optional, like housing?
These need to be considered too, of course. While we’ve already covered the rent vs buy dilemma, there’s still a problem. Many fail to realise what a huge difference buying ‘too much house’ can make.
The Sydney, Melbourne housing boom of the last half-decade (which is now over) has meant the numbers are whackier than ever! So let’s tackle home ownership from another angle and consider opportunity cost in its finest form…
A key factor in our financial strength and freedom is our consumption. Our level of consumption, relative to our income and wealth, dictates how free we really are.
We know that higher consumption doesn’t make us any happier, yet most of us still pursue it.
I know housing has many positive features, many of which make us feel good. But at the end of the day, housing is really another form of consumption. And that’s true globally.
But in Australia, housing is something that consumes us! It seems to own us, rather than the other way round.
We dedicate (terrible) TV shows to it, follow price movements like a national sport and wear our property ownership as a badge of honour. And even after a home is paid off, it still costs a tidy sum to own and maintain.
Anyone serious about saving and getting somewhere financially, needs to optimise their housing choice. Or at least dilute the cost by renting out rooms or sharing.
Anyway, onto today’s example…
Our Investment Property
A good case study is a Melbourne rental house that we sold 2 years ago. We’d held it for a number of years and made a strong capital gain.
So we had a decent lump of equity tied up in the property, yet it was still generating large negative cashflow – (our bills and mortgage were much more than the rent).
As you probably know by now, we decided to sell up and put the equity into shares to create an income stream.
As it turns out, a young first home buyer couple bought our property. Here’s the numbers at the time of sale…
Market rent: $475 per week. ($24,700 per year)
Market price: $1,030,000. Plus stamp duty, and settlement costs.
Because the price had gone up far more than the rent, this house ended up with a rental yield of 2.4%. Pretty low indeed. And this is before costs.
I started to wonder why the couple was so keen to buy when renting would be so much cheaper. Making some assumptions, here’s how the numbers looked for our couple…
To buy this place with a 10% deposit, they were going to have a mortgage of at least $900,000.
With a mortgage rate of 4%, the weekly mortgage payment would be roughly $1,000. Or $52,000 per year.
And this is with record low interest rates.
Then of course there’s also maintenance, repairs, upgrades, council rates, water rates and insurance. This would likely amount to $5,000 a year.
All up, this couple would be looking at $57,000 a year to own the property, or $1,100 per week.
Plus the opportunity cost of having the $100,000 deposit tied up in the property.
Plus the $50,000 stamp duty paid on purchase.
Remember, this compares to a mere $25,000 per year to rent, and no capital outlay.
So we’re looking at somewhere between 2 and 3 times the cost, in terms of monthly cashflow.
And if you look across many suburbs in cities across Australia, these numbers are far more common than you’d think.
But renting is dead money I hear you say. Eventually they’ll have it paid off!
‘Free rent’ is a term I hear used a lot, for when a house is paid off. Awesome, let’s think about that for a minute…
If you have a car loan and pay it off, is your car ownership now free?
No, not at all. You simply paid off the loan. You’ve removed one bill by paying off the loan, but it doesn’t earn you anything. And so it is with a home loan.
Both assets still cost you money to own and maintain. Both provide zero income. They just don’t cost as much as they do with a loan attached.
Now I know some people don’t look at it this way, but I do. I’ve noticed people will tell themselves almost anything to convince themselves they’ve made the right choice.
Let’s see how the numbers stack up if this couple somehow saved up the entire purchase price and bought the house with cash…
House Paid Off
OK, our couple buys the same house for $1,030,000 with cash, and pay $50,000 in stamp duty. This saves them $25,000 in rent each year.
But they still have to pay the $5,000 per year in ownership costs for the house, as detailed above.
Let’s say they’re a frugal couple who is keen to create freedom in their lives and retire early. We’ll assume their only luxury is a well located capital city house, which they want paid off as part of their financial independence plan.
Because they’re generally frugal, let’s say the couple’s other living expenses are a modest $25,000 per year (the same as ours).
So the cashflow on their $1,080,000 net worth looks like this…
Housing costs: $5,000 per year.
Living costs: $25,000 per year.
Total costs: $30,000 per year.
Our couple could probably cover this level of spending with part time work income and can easily leave the full time workforce if they choose. And that’s a great achievement in itself.
It’s not full freedom, but it’s pretty good.
What if they were a bit more flexible and open to another way of doing things?
Instead, let’s see what happens if our couple decides to rent the same property and put their wealth into Aussie shares which pay a solid dividend income stream…
$1,080,000 invested in a couple of Aussie LICs or an index fund, would likely yield over 4% per annum, plus franking credits.
This means their wealth would spit out at least $42,000 per year in cash dividends. Plus around $18,000 in franking credits.
Owning these shares together, each spouse would earn $21,000 in cash dividends, plus $9,000 in franking credits. This gives a gross income of $30,000 each.
Tax owing on an income of $30,000 is around $2,400, which means there’d be $6,600 of franking credits left over and each spouse would get a tax refund for that amount (at the time of writing).
Combined, this means our couple would generate an income stream of at least $55,200, after tax.
And remember, their living costs would be $25,000 for rent, and $25,000 for other expenses – $50,000 in total.
So by putting their magic million to work in a more effective way, this couple is able to cover their spending entirely!
Even if franking credit refunds are stopped, our couple would still earn at least $42,000 after tax. This means they’d only need to earn $8,000 of part time income to cover the gap, versus $30,000 if they were homeowners.
Ultimately, the higher your passive income compared to your expenses, the stronger your financial position.
But, but, but…
I know some of you will think this is a ridiculous example. So be it. There’s no perfect example, and there’s no one size fits all.
There’s always an argument to be made. But I have to share things as I see it. That’s why you read this stuff, right?
Actually, I think this is a perfect scenario to look at.
Why? Because it’s a real trade-off people are making in Australia all the time!
I get that it doesn’t feel like such a big deal because almost nobody is buying a house with cash. And it might not seem like a large difference in monthly cashflow in most cases. But the outcome is the same.
All that extra cash going towards consumption when it could easily be going towards investing.
In my view, the numbers on capital city property ownership have changed. And it’s been heading this way for many years. Long term rental yields continue to fall and overall cost of ownership continues to rise quickly.
Rates, insurance and repair costs are growing faster than rental increases. And stamp duty creep means you’re paying an ever growing percentage of the property value when buying.
People are now paying huge prices (and ongoing costs) for places they can rent for relatively little in comparison. Given our love affair with property, the stigma of renting and our fear of shares, this may well continue.
And that’s sad, because it’s literally costing people their freedom. I believe there are many thousands of people in Australia, young and old, who could comfortably retire if only they removed their rose-tinted property glasses and learned about investing in shares for income.
They’re missing out on financial independence and they don’t even know it. With this blog, I hope to reach some of them!
So do we still think rent money is dead money?
Or do we now realise that’s complete nonsense?
Now, I’ll happily admit renting is dead money if you just blow the savings!
Forced saving is a real factor at play here. So if you think you need the discipline, then simply set up an automated savings plan.
It’s also true that once you’re very wealthy and happily retired with a large taxable investment income, buying a house is a reasonably tax efficient option. But until that point, it’s usually cheaper and more effective to rent.
Rather than following your peers or relying on what worked for your parents, learn to think for yourself.
Luckily, we’ve got some intelligent and independent thinkers around here who have done exactly that.
For example, I’ve received emails from many of you thanking me for sharing another option, other than 100% property investing which seems drummed into us from every angle at an early age.
These people should be extremely proud they’ve questioned the ‘normal’ behaviour around them and decided to seek out other information to forge their own path. That’s not an easy thing to do!
By crunching the numbers first before deciding how much house to buy, you’ll be way ahead of your peers.
One less bedroom. A slightly cheaper suburb. Anything that helps you lower your cost of housing will boost your savings rate and mean more freedom, sooner.
I can’t emphasise enough how important it is to make sure every dollar of wealth you have is contributing to your overall goal.
That means more dollars invested in productive businesses earning a growing stream of dividends, and less dollars tied up in consumption assets like houses and cars.
There’s no point having heaps of equity and no freedom.
I’ve now seen a number of people with a huge net worth and zero freedom. Either because they love the status that comes with their expensive house, they have a distaste for renting, a fear of shares, or simply an irrational level of love for bricks and mortar over other investment options.
I hope you can now see the opportunity cost with owning too much house!
And more importantly, the freedom and choices available for those that focus solely on building an income stream for financial independence, by controlling our consumption and shunning assets which suck away cashflow.
Don’t forget, your financial strength is a measure of your passive income compared to your spending.