5 - How to Spend Money

This is simple but for so many people the concept is something from the stratosphere. My rules are as follows:

1. Don’t spend money
2. Use other people’s money (a mortgage to buy property, interest free periods on a credit card) when you have to spend money
3. Build your credit history (if you’re new to borrowing)

Let me explain in a bit more detail…

1. Don’t Spend Money

This is really the golden rule. Some people might choose to read this as “don’t spend money you don’t have” but see Rule #2 before you adopt that approach. But there’s no need to interpret the wording at all: just don’t spend money!

Although simple in theory, this is extremely difficult for many people to implement in practice. We’re used to spending money and our culture conditions us to spend more money than we need through marketing and advertising and by watching our friends and families succeed. Break the habit, become wealthier, spare the planet the extra plastic, and change the world, maaaaan!!! Ignore the adverts and recognise and accept your friends might be earning more money than you are/in a different financial situation to yours/stupider than you are. Spending money is not a measure of success or intelligence.

If you don’t need something, don’t buy it. Live frugally, is what I always say (rather than calling myself cheap!). Don’t live in the moment and buy impulsively. The time for spending money will come but right now you need to accumulate money and wealth and the easiest way to do this is via the magical effects of compounding, a subject on which I’ll write more about in detail another day. For now, just understand the less money you throw away, the more money you’ll have to make more money.

Before you whip our your credit card, stop and think whether what you’re about to buy is going to increase the number of days (or months or years) you’re going to have a mortgage to repay—or increase the time it’s going to take to save up a deposit for a first home loan. Ask yourself if this doodad, that beer, this seemingly insignificant expenditure is really necessary to your wellbeing and fulfilment. Can it wait another month? Another year? I remember when I first reviewed the interest costs on our PPOR mortgage: over the thirty year term, we would ultimately end up paying the bank the value of our home again. The quicker we could repay the principal, the less we’d pay on interest.

The best way not to spend money is to understand what you need to spend to survive (i.e. a plan or budget—anything), spend that amount and record the transactions against your plan or budget, and treat  yourself occasionally but in moderation.

There are also many subtleties at play here. Never spend money on a depreciating asset like a car—i.e. don’t buy cars, at least not new ones, until you can genuinely afford to. Don’t buy an ultra HD curved OLED television. Don’t waste food. If you’re spending more than $50 a month on booze, you’re spending too much. Definitely don’t smoke or quit if you do. Take it easy on the holidays. Don’t eat out too much.

There are also some really easy things you can do. Buy store brand ketchup instead of Heinz ketchup. Mow your own lawn. Change your behaviours by wearing your clothes for a second season instead of refreshing your wardrobe every three months. Use grocery store fuel vouchers to save on petrol. Pay your bills on time to avoid fees. Ensure you’re never in a position where you have to pay late payment fees or, worse, credit card interest. Make your lunch and take it to work instead of buying lunch every day. Cancel your cable TV subscription. Become a vegetarian and stop eating meat. Ride a bike to work instead of catching the bus or train (or worse, driving your car and paying for parking). As you start thinking like this, you find all sorts of ways to save a few dollars and as my mom always said: “every penny counts!”

Keep the achievement of your long-term goals front of mind and what you give up today is easier to bear. We took on a $700k+ mortgage in 2006; it’s all but paid off less than ten years later through moderate (minimal, really) spending and careful saving.

Edit: Please read my follow up post “Think Rich”—it explores a valid counterpoint to this concept.

2. Use Other People’s Money

If you insist on spending money, don’t use your money, use someone else’s money—at least for as long as you can and if you can do so for free.

Credit cards are considered intrinsically evil by some people but if these facilities are not abused they can be used to your advantage. As long as your balance owing is paid by the due date—that is, you have the cash flow to afford what you’ve purchased—you won’t have any interest to pay for the privilege of borrowing that amount for up to sixty days.

We buy everything (EVERYTHING—except purchases that attract a fee) on a single credit card with a reasonable limit and we pay the credit card bill on time. Our typical credit card bills run between $2,000 and $3,000 (more around Christmas, sometimes less after a really good month); instead of being paid for immediately from our cash, the value of our monthly spend is being lent to us at no charge by the credit card company. During that interest free period, that lent money is working for us in our offset account—reducing the amount on which mortgage interest is charged.

The added bonus is having the majority of our transactions centralised on one card, which makes it easy to know how much we’re spending month to month; it’s also easy to spot any problems. I typically pay off the credit card, in full, a day or two before it’s due to maximise the credit benefit.

The key takeaway here is to never pay interest on your credit card. Most cards will charge interest at an annual rate of around 20%. This adds up to lot of money—I’m always astounded how my credit card statement tells me if I only pay the minimum amount I’ll pay off the closing balance in “58 years and 07 months” and “end up paying an estimated total interest charge of $22,828”! That’s crazy talk.

If you get stuck with credit card debt, plan on getting rid of that debt first before anything else because it will most likely be the highest interest rate you’re faced with (apart from a bad car loan, perhaps). Call your credit card company and have a chat with them about a repayment plan or an interest-free period—ask to speak to the manager if necessary. If your card company won’t help—and by help I mean be very generous to you—roll over the balance on the card to a new card with a 0% introductory balance for 12 months or whatever period you can find. Hopefully that will give you enough time to clear the debt without the interest burden accumulating on top of the original amount.

Finally, I don’t use cards that incur an annual fee just for the sake of a few perks.

When it comes to your home loan, you also need to be careful. If you have a number of debts (i.e. a car loan, credit card, personal loan, etc) you may be offered the option of consolidating all those loans into your home loan. The benefit of doing so is a better interest rate: instead of a 20% rate for your card debt, you’ll be paying 5% at today’s rates. The downside is that debt will follow you for the term of your home loan, meaning the interest on the amount you’ve consolidated will compound every year until it’s repaid—along with x number of years of interest. You could end up paying off that new car for thirty years—long after the car is gone!

You might similarly be tempted to refinance your home to free up equity for a holiday or a new toy (boat?) or a swimming pool. This is easily done but, again, be mindful that in doing so you’re hiding the true cost and using money you can’t really afford.

Credit cards and home loans are generally considered “bad debt” because it’s money that doesn’t work for you. Consider the alternative: “good debt”. This is money borrowed that you in turn use to make money through investing in real estate, a business, or stocks. In contrast to the loan on your PPOR which will cost you money on interest (this interest cannot be claimed as a tax deduction), a investment property mortgage will serve to earn you money. So as a footnote to this section, if you’re buying an investment property, use the bank’s money—secured by the equity in your home—instead of putting down your cash that can be better used elsewhere.

A student loan like a HECS debt is also someone else’s money. If you have the option to reduce interest by making early repayments, ask yourself if the cost of holding onto that loan and not making early repayments will allow you to use that money more productively elsewhere. How much will you save by making early repayments? How much do you stand to make by investing the value of those repayments elsewhere (e.g. in an offset transaction account, saving you interest of say 5% at today’s rates on your PPOR mortgage)?

3. Build your Credit History

If you’re new to property and are looking to take on your first home loan in the next twelve months or so you’re probably also saving for a deposit and implementing a lot of the tips I’ve offered above—good on you. The next step is to ensure you have some form of credit history for lenders to look at when assessing your eventual loan application. To carry on from Rule #2, the easiest way to build your credit history is to take on a single credit card, use it, and ensure it’s paid off in full by the due date. This will help identify you as a borrower with a proven track record of debt repayment—through both intention and financial means.

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 learning too and expect to make many, many mistakes along the way.

Enjoy,

Michael

4 - Risky Business?

Risk is one of those misunderstood concepts that seemingly plagues everything we do: riding a bike is risky, crossing the street is risky, buying property is risky.

I’ve found people throw around the word risk in a very self-limiting way and when it’s used in the context of any random conversation they: 

a) haven’t identified the actual risks that apply to that situation;

b) haven’t classified those risks in terms of their likelihood of actually occurring and the impact if they do occur;

c) haven’t identified ways of mitigating those risks or reducing the likelihood of their occurrence and severity should they occur.

Your mom or sister or brother or uncle will just say “oohhh that’s too risky for me” without understanding why it’s risky. This annoys me to no end because their ignorance suggests I haven’t evaluated risk and am therefore as ignorant and blind as they are myself—I am not!

Experience also reduces the risks that apply and time, of course, redresses many risks—especially in the world of long-term property investment.

Not taking risks could be said to be just as risky as taking managed risks! How else do we move forward as individuals and as a society and culture?!? NASA didn’t put men on the moon without taking risks.

The key to managing risk in any situation is understanding and qualifying the risks that might eventuate.

The example cited above of riding a bicycle is simplistic but the risks of riding a bike are numerous and include falling off, getting hit by a car, riding into a pedestrian, vehicle, animal, or lake, the chain falling off, getting wet if it rains, getting a flat tyre, having to shower when you get to work but having no soap. I used to ride my bike to work every day and these are all real risks!

Having identified the risks, scrutinise each risk in further detail to categorise and rate each one. Here are a few examples from bike riding:

• Falling off: There’s a small chance you might fall off your bike and the result might be of no consequence if you land on your feet or it might be catastrophic if you bump your head. Maybe you’re riding over a loose surface or in the snow. Maybe you’re trying to stay balanced while you’re clipped in at a traffic light. Maybe you’ve made the poor decision to ride home after a few beers on a Friday night after work. The risk of falling off could be decomposed into several risks which are easier to think about and to manage but let’s keep things simple for now. In all cases, you can mitigate the risk of falling off by wearing a helmet and gloves, taking a safe route on bike paths and becoming familiar with the route and all of its hazards, and of course making good decisions while you ride such as unclipping from your pedals at intersections! You could also take out life insurance to cover your healthcare expenses, protect your income if you’re seriously hurt, and reduce your liability if you hurt someone else.
• Flat tyre: This one’s easy: the risk is very low as it’s bound to happen every so often and is something that can be fixed on the spot in ten minutes (or worst case: call someone to collect you and your bike). Mitigation includes not riding over broken glass and fields of prickles; of course, you’ll also want to carry a spare tube or patch kit, tyre levers, and a pump and a flat may make you late for work… which might get you fired.

Don’t forget to take a moment to look at the risks in the context of what you gain, which in the case of our example include improved health (if you don’t fall off!), cost-effective transport and exercise, less stress, nice tan, etc.

In a similar vein, property investment has it’s own set of risks but it’s not inherently “risky”. You’ll want to identify the risks that apply to your situation but this is easily done and takes only a few minutes to think through the details. You’ll sleep better at night having done so—I promise: if your mind starts playing tricks, all you have to do is return to your risk assessment and you can say “nup, that’s a low-likelihood risk and although the consequences are high these mitigations are in place” and carry on sleeping.

Here’s a shortlist of property risks to get you started:

• Buying a low growth property
• Buying a property with expensive problems (pests, asbestos, etc)
• Buying a low cash flow property
• Paying more than the property is worth (i.e. buying at auction)
• Sharks and dodgy investments
• Problem tenants/property management
• Vacancy
• Unexpected repairs/shonky builder
• Interest rate increases
• Job loss
• Hidden costs (stamp duty, mortgage lender’s insurance, council rates, insurance, accounting, management, etc)
• Change in legislation (i.e. taxation laws relating to negative gearing)
• Liquidity
• Capital gains tax
• Selling costs

It’s also important to weigh up the risks you identify in context of the reward—the gains you stand to make if the risks you identify do not eventuate. These might include income through a positively geared property, equity, and wealth.

We mitigated a number of the early risks related to buying by going through Open Wealth but I compiled a risk matrix for each of the risks that do apply in our case, specifically as we move into the post-construction phase. It’s a simple grid. I noted the risk, the criteria for that risk to be fulfilled, probability, impact, ranking, mitigation, and contingency.

Simplistic definitions for these terms are as follows:

Probability:

• Improbable
• Remote
• Occasional
• Probable
• Frequent

Impact:

• Negligible
• Marginal
• Critical
• Catastrophic

Ranking:

• Acceptable as-is
• Acceptable with controls
• Undesirable
• Unacceptable

If, in future, I do encounter one or more of the risks I’ve defined, I have a ready-made framework for understanding those risks—at the very least—and some initial guidance for dealing with them in the heat of the moment. Hopefully I’ve taken steps to mitigate a risk before it becomes a big problem. If nothing else, my risk matrix is an integral part of my strategy relating to property investment and prompts me to think about things that might go wrong before they go wrong—or more specifically—how to measure my success or lack thereof.

Property investment is not inherently risky and I consider it to be far less risky than investing in stocks, where you have no real control over how your investment performs, or leaving in the bank to suffer at the hand of inflation. Many risks in the property sphere are readily overcome and the risk of losing money—or not making money—are often under your control with reasonable opportunities for mitigation.

Of course not doing anything is the biggest risk of all to building your future wealth. Time, conversely, is your biggest ally and will help to remove many short-term risks if you’re prepared to hold and ride out any lumps and bumps.

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

3 - First Steps

There are so many subtle decisions and parallel steps in the property buying process it’s hard to know where to start in describing how we went from A to B. I suppose I’ll start at the very beginning, following our decision residential property investment was the thing for us.

Selecting an Investment Advisor

I’ve written about our “A-Team” previously so won’t reiterate the contents of that post here. Suffice to say we knew we’d need to decide on an individual or company to assist us to select a market, suburb, and property. I considered the risks too high to attempt this on my own, the first time around. You might do this yourself, someone might do it for you at no cost to you, or you might pay someone to provide this service (such as a broker).

I met with a few property investment companies and ultimately decided to move forward with Open Wealth Creation. We aligned to the Open Wealth methodology because it made sense and the Open Wealth team provided a large quantity of quality educational materials at no charge (a reminder, this blog is not an advertisement or referral for any of the entities I mention in these posts).

As we evaluated Open Wealth, I was also interacting with Joyce Property (based in Perth) but I opted not to move forward with them because they also promote and sell apartments; I don’t believe apartments are a good residential investment and I believe if you’re spruiking apartments you’re not working in the interest of those who are investing with your firm. Notably, Joyce does not charge a fee for their services, whereas Open Wealth do charge a fee. Joyce are obviously a very experienced organisation (I met with Graham Joyce and he oozes professional history). 

My wife and I also met with a representative from Investmark and I attended a seminar and had a follow up meeting with IPG but neither were up to the task I set them and seemingly just wanted to shift stock onto naive investors. Their eyes widened when we first explained how much useable equity we had but neither one followed up with me, despite prompting, when I asked them to back up their claims. The free IPG seminar was more or less promising and it seemed like what they were selling was based on good research. At the end of the day, both felt very slippery, verging on dodgy.

Finally, I met with Nicheliving a few times (primarily for their mortgage brokering services but initially for their house and land packages). They’re obviously big in WA but were really pushing us towards NRAS properties and their approach seemed somewhat thick. I knew pretty quickly I wanted to be building in Queensland (Brisbane) but it was worth the discussion with Nicheliving. Nicheliving are a one stop shop, which might be a good thing (or might not!). Their advertising also shows a dude holding wads of cash so it seemed like they target the get rich quick crowd which is not what I’m about.

Getting Money

In parallel with the discussions I was having with these advisors and property development firms, I initiated contact with our current bank and with the mortgage broker we used when purchasing our PPOR.

Although I didn’t intend to send the investment property mortgage to the bank that holds the mortgage over our PPOR, I needed to understand how much equity we had in our family home and, secondarily, how much they thought we could borrow. This turned out to be a good move as the bank was able to very quickly order a full valuation at no charge to me and it turned out to be a very positive engagement in terms of learning how to to converse successfully with the bank. Importantly, because the bank ordered the valuation directly, I was able to get a copy (I wasn’t able to get a copy when our mortgage broker requested a second valuation—which also went through the bank…). 

I wasn’t as impressed with the bank’s view about our loan serviceability—and in turn how much they would lend us; this was due primarily to the fact we’re a single-income family. Nonetheless, the home loan specialist I dealt with was immensely useful in helping me to understand the value of our family home and how we might go about refinancing its corresponding mortgage and optionally financing the investment property purchase. The specialist was also able to share the valuation report with me and it was helpful to see how the valuer saw our property (interestingly, we have a four bedroom house—as per the plans I supplied to him—but he recorded and valued the property as a three bedroom house with a study…).

I didn’t want the bank which has our PPOR mortgage to also hold our IP mortgage because I didn’t want to cross-securitise the loans. I highlighted this when I spoke to our bank and was reassured it wouldn’t be a problem but I’ve read a single lender holding both mortgages will always ensure they come out best in the event of any problems. Yes, we might have secured a lower interest rate and it would have been convenient having everything in one place but I’d only consider a single bank scenario if we eventually get to the world of private banking.

Following that initial conversation with the bank I also got in touch with a mortgage broker. Broker’s are often recommended and, as mentioned, we’d had success with a broker when mortgaging our PPOR (we used Mortgage Choice). You can do your homework and check out products from each of the banks on your own but why bother when using a mortgage broker doesn’t cost you anything and they’re already familiar with countless loan products? The broker I dealt with reassured me Mortgage Choice is paid the same commission for all of the products they recommend, removing the opportunity for the broker to recommend one product above another that will earn them more money; of course I’m not sure how true that is.

Our broker told me he has a few investment properties himself and I think finding people who understand investment property is really important because they’ll have a better appreciation of the path you’re following. As some of our requirements were different to your mortgage broker’s average client requirements (more on that in a moment), I wanted to structure our loans differently than what the broker first had in mind. At the end of the day the broker was able to find the products we needed, submit the applications (he walked through every line on the application forms with me), and secure an interest rate on the main loan that is 0.02% better than what that bank would have offered had I gone to them directly.

With my wife being a doctor, it turned out she was also eligible for a partial LMI waiver (this is one of the interesting requirement I mentioned earlier). Essentially, some lenders will offer members of specific professions an LMI waiver on the basis that they present a lower risk as borrowers. Search for LMI discount or see here for examples—you may be surprised what you find. I certainly wish I’d known about this offer/wish it existed when we purchased our PPOR as we had some major cash flow problems for a little while when we first had to sort out stamp duty and then LMI (and then retaining walls)!

Both of the brokers I was dealing with (Mortgage Choice and Nicheliving) were across the major lenders offering LMI waivers (initially CBA and Westpac but now ANZ and possibly Macquarie and St Georges) and we ended up being able to borrow 90% of the IP costs without incurring LMI. Note the 10% balance was paid from the line of credit secured against the equity in our PPOR but we could have done an 80/20 split if necessary. You can take the latter approach too if you don’t qualify for an LMI waiver but don’t want to pay LMI and have sufficient equity.

Mortgage Choice submitted applications for the main IP loan and the line of credit with our existing lender. Both lenders performed their respective valuations, the first on the property we were buying and the second on our home.

After all was said and (nearly*) done, our unconditional finance approvals came through without a hitch. People get all bent out of shape about finance but I don’t let it phase me—in this case I’d done my homework and knew what to expect. In other words, I wasn’t asking for more than any reasonable person in our situation might need and the numbers were simple and made sense. I was also confident our team would get us through. Might be different next time around though!

* Land settlement is due in the next few weeks. When settlement occurs, the solicitor will meet with the bank and land developer to ensure monies are dispersed appropriately and all of the legals are taken care of.

Land and Builder (etc)

Following an initial phone consultation with Open Wealth and a bit more back and forth, the first thing we needed to do with them was have our name added to a waiting list for a property in the area (the development) they were recommending.

After looking over the property details and the house specifications, we had to sign an “Exclusive Hold Agreement”, which essentially allowed us to deliberate further, and undertake additional due diligence, while the property could not be offered to anyone else. The hold agreement also required payment of a $1,000 refundable deposit. If we chose to back out, the deposit would be refunded in full. This deposit was payable to Open Wealth and is ultimately part of their 2% fee.

With the land contracts submitted, we then had to pay a $2,000 refundable holding deposit to the land developer. This deposit is essentially part of what would be a typical 10% land deposit—there is no further deposit to pay for the land and the balance of the land price and costs are paid at land settlement. The land contracts included the Contract for House and Residential Land (REIQ) and Terms of Contract for House and Residential Land (REIQ), as well as special annexures.

Note we had no opportunity throughout this process to submit an “offer” as such and when I enquired about negotiating on price, I was told the prices are essentially non-negotiable. This is something I want to find out more about if we repeat the process again with Open Wealth.

Next, we had to pay the balance of the Open Wealth “Development Management Agreement Fee” (their fee) within seven days following unconditional approval. This fee is 2% plus GST of the total land and construction price and is tax deductible.

Finally (FINALLY!) we had the 5% builder’s deposit to pay; we were given the option of paying this before settlement so the builder could make a start before we actually owned the land (due to an arrangement between the land developer and the builder negotiated by Open Wealth). We had the option to pay this after settlement.

Note I would have paid all of these costs from our line of credit in order to tax deduct the interest but unfortunately the LOC wasn’t yet available when I paid the $1k and $2k deposits. I may still be able to claim something for these but it gets tricky as I paid both of these initial deposits from our personal transaction account and that gets messy in the eyes of the ATO; will let the accountant sort that one out come tax time! [Update: on advice from our accountant, I “refunded” the $3k to our personal account, in two separate transactions, from our LOC.]

In summary, these were our upfront costs and the timing of relevant milestones:

September

• Exclusive Hold Agreement signed and returned.

October

• Open Wealth deposit: $1,000 (of the total Development Management Fee) to Open Wealth. Refundable.
• Land contracts signed by us and returned.

November

• Land developer deposit: $2,000 (of the land price) to the land developer. Refundable. Payable once land sale contracts submitted
• Unconditional finance approval received. 
• Development Management Agreement Fee: 2% plus GST (minus $1,000 paid initially) of the land and construction costs to Open Wealth. Tax deductible.
• Construction contracts signed by us and returned.

December

• Builder’s deposit: 5% of the construction price to the builder. Tax deductible.

[Update: March

• Land settlement]

Reading and Learning

As all of these events unfolded, I was busily reading everything I could get my hands on. I’ve started a bibliography which I’ll publish soon in case you want to follow what I’ve read. Education is obviously a time consuming (and at times tiresome) activity but I feel it’s important to understand the principles of property investment inside and out—especially as I lack the repeated experiences myself.

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