47 – How we saved 1 million dollars tax free

You may not have realised but the mortgage on your family home is one of the most flexible and safest “investment” vehicles available to you.

Let’s start at the beginning, with the basics. Say you take out an owner-occupier, principal and interest home loan from a bank for $750,000; the loan is for thirty years with a variable interest rate of 5.25%.

As an owner-occupier you’ll live in the home (note different factors, such as tax deductibility, are at play with an investment loan). Your interest rate will rise or fall depending on several factors, including the RBA’s official cash rate, regulatory changes—such as those implemented by APRA in recent years, market conditions, and the business outlook of the bank itself (such as exposure to business issues in other industries or countries).

As a principal and interest loan, you’ll start by paying off the interest (mainly) and your regular repayments will likely be about $4,100/month. You’ll pay that amount every month for thirty years. After 360 payments, you’ll have paid off the principal amount of $750k and nearly $750k again in interest.

So in a nutshell, your house will cost you twice as much as the price of the house itself if you take on a mortgage (I’m glossing over deposits and stamp duty, of course). That’s a lot of money!

This is why my #1 tip is to pay off your mortgage as soon as you can. To achieve this, negotiate annually with your bank to secure the best interest rate you can and move banks if you’re not happy; employ an offset account (don’t use redraw) to ensure all of your cash is being used to reduce the principal owing; switch to fortnightly or weekly repayments; throw everything you’ve got at your mortgage until it’s at least well under control if not obliterated—and by this I mean scrimp and save and defer buying the things you want for a few years.

Many banks and financial institutions offer interactive, visual calculators which demonstrate how changes in interest rates and repayment frequency will affect the total cost of your loan. Check out this calculator from CANSTAR, as one example. It was the looming threat of having to pay thousands of dollars every month, illustrated in a calculator like this, and the idea that our house would cost twice as much in interest, that drove me to our strategy of removing our home loan from our lives. 

If you’ve got money squirrelled away elsewhere, it’s probably time to liquidate and toss it into you offset account. If you’re using a high interest savings account, the ATO will treat your earned savings as taxable income (which will be taxed at your marginal tax rate). The same goes for capital gains income from other investment vehicles such as stocks. Don’t forget your savings are also being eroded by inflation at a rate of ~3% every year—meaning your cash loses 3% of its value once every year to the point where you position is probably moving backwards.

Ask yourself if your other investments are earning you a return of 5% p.a. or more, after CPI and tax—where the 5% figure is taken from interest rate on your mortgage. You’ll likely find they’re not. Don’t forget to consider your risk exposure with these investments: when the next dotcom crash or GFC arrives, will your investments hold their current value?

By contrast, you live in your home and, while it’s not an income-producing asset, it is a huge (albeit generally low-risk) liability which will undermine your ability to purchase strong assets if not reduced. That said, no matter what happens, your house will provide you with shelter and warmth and privacy even if it drops in value or the worst happens: it’s something you can use.

Suppose you are taming the bear that is your mortgage: you’re chipping away at it using an offset account and making extra repayments. Meanwhile, the value of the security—the land on which your house sits—has likely increased in value. If you need a large amount of cash for that rainy day emergency, it’s immediately accessible to you from your offset account or by redrawing. In other words, your mortgage as a “reverse investment” (if that makes sense!) is not only low-risk but it’s fluid in that it can be rapidly converted into cash.

With the passage of time and increase in value of your property, you may now be able to take out a line of credit, effectively a mini-mortgage secured against the difference between the current value of your property and its original value or what’s been paid down (the equity but this is also called your “lazy money”—set it to work for you!). You could go silly and use this to fund a holiday or buy a fancy car but that would undo your hard work. Instead, use that available money to pay a deposit and costs for your first investment property. Welcome to the world of leverage.

The above is exactly what we did and we effectively paid down our mortgage in full in about eight years (ours was largely a dual-income family on average salaries for the majority of that time). From the line of credit, we’ve been able to extend ourselves into two investment properties, all the while saving somewhere between $500k – $1m in interest (depending on future interest rates), paying no additional tax, and watching the value of what is now our home increase rather than moving backwards, as cash would have.

I suppose a disclaimer is also worth posting: I'm just a guy, I'm not an accountant, lawyer, solicitor, tax agent, mortgage broker, banker, financial adviser, insurance agent, land developer, builder, government agent, or anything else so I disclaim your application of anything I write here is to be applied at your own risk. What I write may be incorrect and you are best to seek your own professional advice (tax, legal, financial, and otherwise) before entering into contracts or spending your money. Your situation is unique to you and what I write here reflects my experience only. This content is not professional advice and is not tailored to your situation. I’m not selling anything and I do not receive any form of commission or incentive payments for any companies or individuals I endorse. I'm learning too and expect to make many, many mistakes along the way.

Enjoy,

Michael

Setting the Scene

I’ve previously mentioned property investment and that’s what I’m here writing about (or will be soon once the formalities are out of the way). So before we get started in earnest allow me to explain why we felt the need to invest. As always, I’ll go into specifics in future posts—I promise.

Our pathway through life has been, to date, very much what most people would expect: grow up, go to school (university), get a good job (refer to Robert Kiyoasaki’s excellent Rich Dad Poor Dad book for more on this mantra). You might follow that with work hard, retire, die.

In my case, I opted to start my tertiary education in the arts to lay the groundwork for future specialisation so I studied English Literature and Art History. I followed that with a Masters in Information Technology.

My wife followed a similar path, starting out in veterinary studies before shiftingd over to medicine.

I did alright, academically, in my undergraduate degree and did very well in my Masters degree. The wife did very well throughout. I landed in a pretty good job out of university and my wife entered the public health system to complete her training.

Our incomes grew rapidly as we progressed from junior positions in the first few years of our respective careers and we soon focused on buying a block of land and building a house. We saved enough for a deposit on the land and took on a mortgage worth a lot of money (not quite three quarters of a million dollars at the time—2006—but close enough to make me uncomfortable) for the purchase costs and the build. Interest rates were higher then and bounced around a lot but we were protected by naivety, our double income, and a thrifty nature.

We went to work. We paid our mortgage (which cost over $4,000 a month in the early days). We saved a bit where could, using high-interest savings accounts—and paying tax on the interest of course. We were scared to spend and saved hard to establish a buffer or rainy day account.

At one point, the CIO I was working under suggested to me the best thing we could do with our saving was reduce the interest costs on our mortgage by pushing our spare cash into the included redraw facility. If you’re not familiar with redraw, it works very much like an offset account: any money you put in reduces the principal on which you pay interest. Whereas an offset account is a separate transaction account, a redraw account is basically your mortgage account. The cash you push in can just as easily be pulled back out again. It’s not quite as flexible as an offset account but redraw didn’t attract any fees in our case.

Important note: there are significant downsides to redraw if you ever want to turn the property into an investment property—against which  you would likely want to claim tax deductions. The ATO considers payments into redraw as payments which reduce how much interest you can claim. So watch out for redraw and prefer an offset account instead which doesn’t have the same problem.

From this simple idea was born our financial strategy: manually move cash into the redraw account when it was available, thereby reducing interest costs. This approach would save us hundreds of thousands of dollars and result in the mortgage being paid off early. Oh and there would be no tax to pay (if our cash was instead held in a high-interest savings account or other investment vehicle we would pay tax on the earnings).

Meanwhile, the equity in our home was increasing. It’s now 2014, we’ve owned the block of land since mid-2006 and been in the house since mid-2008. As we worked at our jobs, the property market—and the property cycle—kept working in our favour too, ensuring the value of our house was aligned to the median house price and comparable recent sales in our area.

In round numbers, let’s say we’ve been living in the house for five years; in that time, the equity in the house has increased by over $400k. Of course there’s inflation to contend with and we spent close to $100k on very necessary post-construction activities like pouring a very long driveway (we’re on a rear block), building a deck and pergola, fencing, tiling, painting, carpets, blinds, built in vac, etc, etc.

Equity, locked up in a family home is like almost-free money. That’s simplistic, of course, because to access that “money” really and truly you’d need to sell the house and crystalise the gain which most people probably won’t want to do if they’re living in that house. But—and very importantly—the banks will loan money against that equity using a line of credit or an equity loan. You’ll pay interest just like any other bank loan but you can effectively do whatever you want to with that money such as use it to pay for a deposit on an investment property (or buy stocks or go on a holiday or whatever—but ask an accountant about the idea of mixing the purpose of the loan before you do anything other than attempt to generate money). A line of credit can be established for smaller amounts but can go quite high too—the bank site I’m looking at as I write suggests $750k and up.

At this point, we have a problem. We’ve got a plan to pay off our mortgage in ten years or less (by paying less interest, basically) and we’ve got increasing equity in our home. That’s good problem to have, I suppose! It also sounds like lazy money to me: money—or rather other people’s money (the bank’s)—that could be working for me to make more money (so I don’t have to) but that hasn’t been put to good use.

Following an initial conversation directly with our bank I realised we could be approved for an investment property mortgage and could effect the transaction with no money from our own pocket. Really. Nothing. We couldn’t get a 105% or 110% loan because they aren’t offered by the mainstream lenders post GFC but by combining a line of credit with an investment home loan we could cover all of the purchase costs and we’d avoid paying mortgage lender’s insurance.

Rental income would cover a significant majority of the ongoing costs and tax deductions would take us up near 95%, leaving only a small difference for us to pay. By my (pessimistic) calculations that works out to $4,000 or less a year.

The property will therefore be “negatively geared” but the plan is for it to become neutrally or positively geared in the years to come meaning it makes money (“net cashflow positive”) and costs me nothing in the long-term. All the while the equity in this first property is growing and can be used for other investments.

So we’ve redefined our financial strategy—I plan to dedicate a future post that topic. In short we’ve now outgrown what was a simplistic and great plan (put it all in redraw!) and are now thinking long-term and bigger picture (through retirement and on to death). I’ve done a lot of reading over the last six months and spoken to brokers, accountants, other investors, lenders, and solicitors to understand the moving parts when it comes to property investment. I have a lot more learning to do however!

I’ll write more about risk in the future as well but the way I see it property is in a sweet spot between shares and savings accounts. Understand the risks and they seem rather manageable for the long-term returns you hear about. [Update: see my post Risky Business? for my views in this area.]

A side note: I earned ten thousand dollars one summer as a young man planning bus routes for the school board in my area. Another long story but that money was invested in a handful of tech stocks around 1998/99—just before the tech bubble burst, if you’ll recall! I watched some of the five or six stocks I held soar magnificently in value but was mentored to hold for the long term and I neglected my instinct to sell and cash in the gains. The bubble burst soon enough and my $10k became almost worthless in a short matter of time. In retrospect, I probably bought when prices were already high so the correction left me hanging in the wind. In the next decade that money would have come in terribly handy for immigration to Australia, getting married, studying as an international student, and buying our first home. Of course by that time it was long gone. It’s easy to call stocks a gamble but there are reasons why I have no interest in stocks (to list some of those reasons quickly: market mentality, lack of control or direction over the investment, lack of time and interest to understand company fundamentals, and so on).

Super would be fine and dandy—apart from the fact any contributions are locked away until you reach your preservation age (55 in my case) and the canned investment options are built around securities (and property and cash). Self-managed super would be great, especially when it comes to property investment, but then the ATO won’t allow you to buy a block of land and improve it (build) and building new is what maximises your depreciation benefits.

Other options we considered were to simply save our income. This is simple and surely it’s safe, right? The bank guarantees your savings but it won’t protect your savings from inflation (which is roughly 3% a year on average). Most importantly, your money isn’t working hard enough, even if it is keeping pace with inflation. With interest rates so low, high-interest savings accounts are still quite boring in terms of their returns and term deposits, etc aren’t much better as far as I know.

So we’re starting with property. It costs very little to build an asset base that will grow in value over time and allow us to save tax. Our strategy, if you can’t tell, is very much buy and hold—forever.

Hopefully that gives you some context for the stories and tales that follow. Our situation is unique in that it is our own but in dollars and cents I think you’ll find we’re not all that different from you or your friends and neighbours. There are no secrets and no magic tricks. Yes, there are tricksters and sharks who will attempt to lead you astray and while they may not steal from you, you may not get what you expect in return for payment. There are alternative strategies and approaches you’ll come across, of course. And there is plenty to learn: the financial aspects are fascinating and then of course there’s the tax office and different state laws and functions to consider. As a simple person, however, I don’t believe this stuff is beyond my grasp… but I’ll keep you posted either way!

I suppose a disclaimer is also worth posting: I'm just a guy, I'm not an accountant, lawyer, solicitor, tax agent, mortgage broker, banker, financial adviser, insurance agent, land developer, builder, government agent, or anything else so I disclaim your application of anything I write here is to be applied at your own risk. What I write may be incorrect and you are best to seek your own professional advice (tax, legal, financial, and otherwise) before entering into contracts or spending your money. Your situation is unique to you and what I write here reflects my experience only. I'm learning too and expect to make many, many mistakes along the way.

Enjoy,
Michael