October 27, 2017 Paula Benson

Is Rent Money Dead Money?

In the eyes of a 24 year old

Let’s face it; at one stage or another, we have all been advised that rent money is dead money. Sound familiar? Maybe you can relate to one of the following examples:

  • ‘Why would you pay all that money so your landlord can pay off their mortgage?’
  • ‘Why would you waste all that money when you’ll have nothing to show for it?’
  • ‘If you had of been paying a mortgage off instead, you have paid off your most valuable asset.’

Firstly, the definition of an asset is something that pays you.

The definition of a liability is simply something that you are required to pay for.

Let’s take these definitions and apply it to our situation when we own a house.

A house:

  • Asks us to put our hand in our pocket to pay for it
  • Accrues rates & insurances
  • Requires all kinds of maintenance
  • Even the government takes their slice of our property thanks to stamp duty – great!

I now ask you, is your house truly an asset?

Circling back to the age-old question in Australia: Is rent money, dead money?

I’ll counter by asking: is interest payable to the bank dead money?

If you were to borrow $400,000 tomorrow at today’s record-low interest rates, and make principle and interest repayments at 4.5% over 30 years, you would repay $729,130, with your initial weekly liability being $467. Not too bad? $211 of which is the interest portion of your loan. Meaning, over the course of your loan, you would pay an approximate $329,626 in interest to the bank. Thank you very much says the CBA CEO. **

So, assuming a 20% deposit, it is costing you $467 per week, or $24,288 per year, to live in a house with a perceived value of roughly $500,000. But is it? At Income Solutions we reasonably assume annual expenses (rates, maintenance, etc.) to average at least 1.5% of the property’s value each year. Therefore, throw around $7,500 on top of your existing $24,284. Roughly, on average, it will cost you a touch over $31,000 per year to run the house you own.

Let’s say I rent the same house at an assumed rent price of $450 per week. This works out to be around $23,400 per year. And that is where my dwelling expenses stop. As a tenant, I have no obligation to pay any maintenance, rates or property management fees. This is the landlord’s responsibility. I simply pay my rent on time, and because my dwelling expenses are so low, I do not make a fuss when my landlord attempts to increase the rent by $20 a week every few years. As I pay on time and look after the place, the landlord is more than happy to keep re-signing me to 2-year lease agreements, providing me some security. Therefore, I pay $450 per week, compared to the landlords $611[1].

This is where renting becomes interesting. I am paying $161 less than the landlord/homeowner per week, so let’s say I use this, add another $50 to equal the $211 the landlord pays in interest in year 1 of the loan[2] and contribute this to a tax-effective income-producing asset, over the same 30-year period.

Basically, the difference between what I pay in rent per week, and the total amount the landlord/homeowner pays to own the home per week.

Assuming an annual return of a conservative 9.5%, (the Australian Share market has averaged a return of around 12.5% over the past 100 years) the power of compounding becomes your friend here, as my $211 weekly investment for 30 years would grow to a modest $2.9 million dollars. Again, this is a conservative figure, and it also assumes I never contribute more than $211 per week over the course of my working life. I’ll be 54 by this stage, and thanks to the Franking Credit system, this $2.9 million can reasonably produce me a cool, highly franked, beautiful income stream of approximately $178,000. Enough to retire, I think.

At the end of the loan period, the homeowner is hoping the value of their property has grown to at least equal to the total amount spent on the property, which in this scenario is around $945,000. If they were 24 when they bought the home, they have finally paid it off at age 54. However, they have had to find more disposable income on top of their weekly $611, which has been swallowed by their house for 30 years, to contribute to some form of financial asset. They may own their house outright, but we know our house does not produce us any income, it actually asks us for a share of ours to service it. There is a potential that they will be examples of the typical ‘asset rich, income poor’ description we sadly see too often in this country.

By renting and spending the same $611 per week, I can own an asset and not a liability. If I would like to own my dream home, I will simply withdraw the $945,000 from my investment and pay for it in cash, no interest paid to the bank. Furthermore, I’ll still have around $2mil producing me highly Franked income.

Rather than paying interest to the bank, I’d rather get paid by the bank.

 

Now, is rent money dead money?

 

*All figures are present value.

[1] This includes the P and I repayments, and the averaged costs of $7,500, broken down into a weekly figure.

[2] The interest payable will reduce over the loan term, however, the $467 will remain constant.

https://www.yourmortgage.com.au/calculators/home-loan-repayment/result/

Any advice in this publication is of a general nature only and has not been tailored to your personal circumstances. Please seek personal advice prior to acting on this information. The information in this document reflects our understanding of existing legislation, proposed legislation, rulings etc as at the date of issue. In some cases the information has been provided to us by third parties. While it is believed the information is accurate and reliable, this is not guaranteed in any way.  Opinions constitute our judgement at the time of issue and are subject to change. Neither, the Licensee or any of the National Australia group of companies, nor their employees or directors give any warranty of accuracy, nor accept any responsibility for errors or omissions in this document. Before making a decision to acquire a financial product, you should obtain and read the Product Disclosure Statement (PDS) relating to that product. Past performance is not a reliable guide to future returns. 

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