With my most recent purchase of property number 3 I thought it would be a good chance to clear up any misconceptions about how much it really costs to buy a property and what are the hidden fees, extras and everything else involved right from step 1 to getting the keys.
The most important part of the transaction. The purchase price is where you can really set yourself apart from an investor that knows what they’re doing as opposed to the investing n00b that rolls into a Metricon display home and picks a house off the shelf (this was actually me on my first IP LOL). It’s probably the most important part of property investing, sure you make a woad of cash over the years as compounding interest does its thang. But to really steamroll ahead in the investing game, getting a bargain on each property you buy is vital. It not only gives you a buffer in place in case you had to sell, but more importantly you will see growth WAY sooner than if you bought like 80% of people do, at market value or over.
Yes, I know what some are going to say “Whatever you buy at IS the market price”. True to an extent, but what really matters is how much the bank values the property at. And they usually undervalue the property a tad to mitigate their risk. So if the banks valuation comes back higher than what you paid for it, well done!
The big one. All that hard work and years of savings form your deposit. How much deposit do you need though? Everyone has a different opinion on this one but here’s my take.
If you’re buying a home to LIVE in and not to invest then how big a deposit you put down doesn’t really matter. You probably want to avoid lenders mortgage insurance which is an insurance you have to pay for the bank when your deposit is less than 20%. Isn’t that funny? The banks see less than 20% deposits as high risk so they rightfully take out insurance to cover themselves in case you default on your loan. If that was to happen, the banks would get paid out by their insurer and the insurer would then come after YOU! The funny thing here is that you have to pay for the banks insurance. Imagine if every landlord started charging each tenant-landlord and home insurance because they see them as high risk. It just wouldn’t happen. But the banks have the mula $$$ and they make the rules. So us mere peasants just have to cop it on the chin…OR place down a 20% or bigger deposit.
If you are investing in property however my view on this is a bit different. You can put down less than 20% and pay the extra in fees (thousands of dollars extra depending on the size of the loan and your deposit %) if you are desperate to get into the market because you think it’s rising faster than you can save. For example, lets say that you want to buy an IP for $400K which would require a deposit of $80K (20%) but you only have $60K right now. A year passes by and now you have the extra $20K but now you discover that houses are selling for $500K instead, that means you would now need an extra $20K for your deposit. If you had bought the property at the start with a lower deposit, you would have had to pay the LMI but you would have seen a $100K increase in equity after one year which easily offsets the pain of paying the LMI.
Paying LMI in this case is beneficial but if the value of the property doesn’t rise then you will be stuck with a property with a loan to value ratio (LVR) of greater than 80%. The issue with having a property with an LVR of greater than 80% is that if you want to pull out equity, lets say upto 90% LVR you will have to pay LMI again 😐 . This actually happened to me on my first IP and was quite a shock. I’d already paid LMI to purchase the property but then they slugged me AGAIN when I pulled out equity. Lesson learned. I now only withdraw equity when my property is less than 80% LVR. The banks (my bank at least) allows me to pull out equity up to 80% LVR with no charge attached and it’s a pretty straightforward process.
I put down 20% for each IP that I buy these days but I don’t put down any more than that. Why? Because a 20% deposit I feel is the sweet spot for not only dodging such extras as LMI but also providing a big enough buffer in case anything went wrong and you had to get out.
Some people say the bigger the deposit the better. I disagree. One of my favourite ways to evaluate a property (or any investment) is to calculate the cash on cash (COC) return. The formula looks something like this:
COC = (INCOME-EXPENSES) ÷ CASH INVESTED
I like it so much because it can tell you how quickly you are going to get back your initial outlay that you parted with to buy the investment to begin with. Using this formula you can work out that it is not always the best idea to put down a bigger deposit. Lets for example say that you are looking at purchasing a positively geared house in the country that doesn’t have the brightest future for capital growth but has a really strong rental yield. The purchase price is $170K (yes these houses do exist if you look outside of capital cities) and it is currently tenanted at $290 P/W. Rounding the figures off lets just assume that all the expenses including interest, rates, water etc. all add up to be $9K P/Y. That’s roughly $15K a year from rent and expenses of $9K, which is fantastic positive cash flow straight off the bat of $6K P/Y. Lets say you purchased this deal with a 20% deposit. At 20% deposit you are forking out $34K plus 5% overall buying costs which brings you up to $42.5K OVERALL cash invested. If we plug that into the formula
COC = $6K ÷ $42.5K
COC = 14%.
Assuming no capital growth and not adjusting for inflation this means that at the current rate of return with all things being the exact same, I will get back my initial capital that I invested into this asset back after roughly 7 years. Every $ after those 7 years is pure profit. Now lets change the deposit size and see what happens to our COC return. Let say I was to only put a 10% deposit down instead of 20%. I’m now paying an extra $850 (assuming interest rate @ 5%) bucks each year because my loan is bigger and lets say LMI is going to cost me $3K. My cash flow now changes from 6K P/Y to $5.15K but my total cash invested also changed from $42,5K to $28.5K. So if we now plug those figures into the COC formula we then get the following
COC = $5.15K ÷ $28.5K
COC = 18%
The higher the COC percentage the quicker you get back the money that went into any investment. We could do the formula again with 0% deposit (banks don’t currently let you do this now, they did once upon a time) and the COC would be even bigger, sometimes over 100% meaning you’re making real money from the very get-go.
It’s all about how comfortable you are with risk. I’m not saying to put down the smallest deposit possible I’m just saying that purely from a mathematical point of view you are not always better to be putting down 30% to 60% deposits when you’re investing in real estate. If you want a place to live in then it’s different because your primary goal is not to make money. But if you are looking to make money from investing in property then there are better ways to do it then to put down a big 40% deposit on a property that’s going to take 40 years to generate enough income just so you can be back at square one from where you started from.
This will vary on a number of things but I have used the 5% rule in the past and it has been pretty much spot on for all three of my properties so far. It’s pretty simple really. 5% of the purchase price is usually what it’s going to cost you to buy the property. This covers everything like building and pest inspections, stamp duty and legal fees. It’s a bitter pill to swallow sometimes because if you are buying a property worth $500K, using the 5% rule would mean you are paying $25K just to own this asset. That’s a LOT of money just to buy something which is why a lot of property investors don’t like selling once they have bought. It’s expensive to get into the market and even more so sometimes to exit. I would have to agree with this mantra. You lose enough money as it is through buying fees let alone selling ones. Below is my actual buying costs of the latest property to give you an idea not only of the prices but also the timelines on which I had to pay them. FYI the purchase price was $250K
|29-Jul-2015||$400.00||Building and Pest inspection|
|11-Aug-2015||$11,500.00||More of the deposit|
|16-Sep-2015||$37,900.25||Rest of Deposit|
|16-Sep-2015||$2,078.83||Legal and conveyancing fees|
|25-Sep-2015||$728.40||Land Titles Office|
From my experience, I have found that I can quickly and easily work out how much it’s going to cost me to buy a property using the 5% rule and 20% of the purchase price. For me, it works out to be 25%. The 5% rule can be applied for most purchases but the other major part to the buying cost is the deposit which will differ from person to person. Do you always aim to put 20% deposit down? Maybe more? Maybe less? I’d like to know your reasoning behind it in the comment section below.