Australians have an obsession with debt. We love leveraging our home or investment property to buy new family cars, boats, and pay for renovations and lavish holidays. I understand, it can be very tempting. After all, if someone told me I could buy a brand new Mercedes-Benz for $60 a week by leveraging the equity in my home, or pay $1,400 a month for the same Mercedes-Benz with a secured car loan, I’d be tempted to buy one with my home equity too.
I strongly believe that consolidating debt is necessary if you want mortgage freedom. Where things go astray for most people is the “upgraded” lifestyle that takes place simultaneously.
If you have a home with enough equity, you’re generally able to leverage that equity to pay off your credit cards, personal loans, car loans, and most other credit facilities. In theory, this is a great idea.
However, adding $5000 onto your mortgage to pay off your credit card will do more harm than good if you then go and rack up another $5,000 in credit card debt. The goal should be to keep your credit card balance at zero and your credit card limit as low as possible. The idea behind consolidating debt is to improve your cash flow situation as you pay off loans that attract higher repayment requirements and higher interest rates. In turn, this allows you build equity and wealth. As I’ll explain later in the book, cash flow is critical when trying to acquire investment properties.
The example below is a true scenario where a client came to Atomic Home Loans asking for advice on how to help their two sons buy one investment property each. The idea was for them to move out of home and into those properties in a few years time.
David and Susan have worked their entire adult life. About 20 years ago they purchased their first home for about $150,000. The most recent valuation on their property indicated a market value of $1.3m. When they initially approached me, the outstanding loan balance was $290,000.
Their two sons Matthew and James were both earning a decent wage but they were struggling to get their foot onto the property ladder.
Between the four of them they had four cars with approx. $120,000 in outstanding debt. These four cars were costing them about $2,800 a month in repayments, while the mortgage was costing them approximately $1,500 a month.
They had no other debt or credit facilities.
In total, they were paying $4,300 per month in loan repayments before any living expenses were accounted for.
Their home loan attracted an interest rate of 4.9% while the cars attracted rates of 6% onwards.
We were able to refinance their mortgage and secure a rate of 3.79% for a loan of $642,000. We refinanced the $290,000 mortgage, paid off the $120,000 in car loans and released $232,000 of equity into cash, which was to be used for deposits on their sons’ investment properties.
This provided Susan and David immediate savings through a lower interest rate and a lower monthly repayment. Previous monthly totals were $4,300; updated monthly commitments came in at about $3,050.
The additional borrowings of $232,000 were used as two deposits for two investment properties- one for Matthew and one for James.
We helped Matthew and James purchase one dual income property each in the Newcastle region. Both properties were identical in design and were sold as land and house packages for $578,000 each.
In case you’re wondering, a dual income property is one with a house and a granny flat attached to it. Or, more commonly, it is viewed as a duplex (although there is a difference)
Thanks to their parents, Matthew and James were each able to put down a 20% deposit and borrow the remaining 80%.
For Matthew and James, the principal and interest repayments on their loan of $470,000 worked out to be $520 a week. Given these are dual income properties, they attract a combined weekly rental return of $670.
In essence, the tenants are paying off the mortgage while the weekly surplus of $150 is being used to pay down the loans even quicker.
Matthew and James, if they simply maintain the repayments equal to the rent they receive, their properties will be debt free within 20 years, and it won’t cost them anything out of pocket.
Both Matthew and James plan to repay the $116,000 loan their parents provided them with.
So not only did David and Susan reduce their monthly commitment by about $1,300, they successfully helped their two sons acquire a property each.
There is nothing more satisfying than helping those you love.
CASE STUDY SUMMARISED
House : $1,500 per month Consolidated House + Cars: $1,950 per month Cars: $2,800 per month Cash out of $232,000: $1,100 per month Total monthly: $4,300 Total monthly: $3,050 Total Weekly Cost: $993 Total Weekly Cost: $705 They had 1 property and 4 cars, paying $993 per week. The positive cash flow of $300 from the 2 investment properties means they only need to come up with $405 per week between the 4 of them to meet the minimum weekly requirements across the 3 mortgages.
As a family, they now have 3 properties and 4 cars, costing them just $405 per week
Please note this is fairly simplified illustration of the scenario. The figures used above are pre-tax dollars and assume an interest rate of 4.05% on the investment loan. It also doesn’t take into account any depreciation benefits from the investment properties, which would make an even greater positive impact on their weekly cash flow situation.
*For privacy reasons the names used in this case study are not the real names.
Although a great result for the family and a clear illustration of the potential that debt consolidation and wise investing can do for cashflow and wealth creation, you need to be aware of the fact that the loan term is now 30 years for the entire loan amount. Previously, the car loans (totalling $120,000) had higher repayments and higher interest rates, but they would have been paid out completely within 4 years.
Isn’t that a bad thing though?
Well, yes. If they pay the absolute minimum on the new loan, then they’ll almost certainly end up paying more for the cars than they otherwise would have.
|$120,000 over 4 years
Average Interest rate of 8% p.a.
Total paid back: $140,618
|$120,000 over 30 years
Average interest rate of 3.79%
Total paid back: $201,048
As you can see, despite the lower interest rate, paying the car debt off over 30 years rather than 4 years ends up costing an additional $60,000!
What is recommended when consolidated this debt is to maintain the repayment amount they previously had, i.e. $4,300 per month, if at all possible. In addition, the surplus cash flow from the two investment properties, totalling $1,300 per month ($300 per week, 4.33 weeks in a month), would be used to make extra repayments on the mortgage. So now they’ve got a total of $5,600 a month being contributed to the mortgage, rather than just the minimum of $3,050 per month.
That is, they will now be contributing $2,550 in extra repayments on the loan. As a result, they will have their current $632,000 mortgage paid out completely in 12 years and 1 month, while James and Matthew will be responsible for 1 of the newly acquired investment properties.
For our clients, David and Susan, the best part of this strategy wasn’t the financial saving – although that certainly was a plus. It was the feeling of being able to give their sons an opportunity to get onto the property market and create their own long term financial security.
Should they not have proceeded like this, who knows when Matthew and James would have been able to get on to the property ladder.
When consolidating debt, it’s best to maintain the higher repayments if possible, even though the minimum repayment amount might not require you to do so.