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.
Purchase Price
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!
Deposit
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.
Buying Costs
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
| Date | Expenses | Notes |
| 27-Jul-2015 | $1,000.00 | Initial deposit |
| 29-Jul-2015 | $400.00 | Building and Pest inspection |
| 11-Aug-2015 | $11,500.00 | More of the deposit |
| 2-Sep-2015 | $7,175.00 | Stamp Duty |
| 16-Sep-2015 | $37,900.25 | Rest of Deposit |
| 16-Sep-2015 | $2,078.83 | Legal and conveyancing fees |
| 25-Sep-2015 | $200.00 | Settlement Fee |
| 25-Sep-2015 | $728.40 | Land Titles Office |
| Total | $60,982.48 |
Conclusion
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.
x
I went with low deposit in order to try capitalise on rising Sydney market. I think it’s paid off… Reval next Tuesday will tell me for sure!
Hi mate, how did you reval go? Was it good news?
I’m just about to share the news in my latest Net Worth update. Should be posted by the end of the week 🙂
Hi mate, how did you reval go? Was it good news?
Hey I am in different situation. Curtley holding two IPs and one PPOR in WA. Falling market, interested to hear your ideas
That’s a little vague, to be honest. What exactly do you want to hear my ideas about?
Interesting read.
I’m a big believer that a bigger deposit in buying a house to live in, helps get the banker off your back quicker. They say renting is dead money. So is paying interest on a large mortgage.
Living debt free gives you amazing choices in life and something I’m focusing on my young adult children to follow In order to achieve this.
You do make some valid points with IP purchases but I’m in the sharemarket corner with building my wealth.
In your COC example, you’ve said that “everything after 7 years is pure profit”. Are you including the loan principal in your expenses? Are you paying the loan principal? Perhaps its profit because its an interest only loan?
Not criticising – just a noob trying to work this out!
Hi Adrian,
I’m not including the principal. I don’t pay off principal on any of my investment properties. Surplus cash from the properties goes into the offset account each month.
Some property investors pay down their loans, but I’m not one of them. My reasoning behind this is that I believe I can make a better return with my money in other investments vs paying the loan principal and effectively receiving a return of whatever my interest rate it.
I hope that answers your question.
Hi good article. Building from Adrian’s comment, if you are only paying interest only loan, correct me if I am wrong but you can only do that for a few years before having to start paying off the principle, where your cash flow will significantly decrease?
You’re assumptions are sort of correct.
The I/O period for my loans is 5 years on each. Now a few years ago what was happening was that when you reached the end of the I/O period you would simply refinance and get it either extended from your current bank, or find a new bank.
But in today’s market with all the ho ha’s going on with the banks. They are not extending the I/O periods for the majority of loaners. This could be disastrous for some as you have mentioned, their cash flow will be severely impacted.
I can absorb an increase of around $9K p/y before I would need to start dipping into my own pocket. But with three IP’s and interest rates on the rise… It wouldn’t take long. I might be offloading one of the IPs this year to reduce my exposure from this risk.
In a similar situation that my 5 year IO loans will come to an end in 2020. Whilst I get the banks intention to reign in investor loans, surely increased expenses for investors moving to P&I loans will just be passes on in the form of rent increases which will just make life harder for renters, not investors in the long run?
Maybe… I guess we’ll see if it happens right.
Try doing that in WA right now – properties are worth up to 20% less than purchase price and rents are down too as are wages for most people (thanks mining crash) So for a lot of investors, we can’t sell, can’t increase rents and don’t have the cashflow to fund P&I mortgage payments. I personally know more than one person who will have no choice but to go bankrupt this year as banks have already said they are not prepared to refinance IO loans as interest only.
Investment properties and the associated debt are great when the market keeps going up, but not so much fun when it tanks.
A bit confused about this line “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 ”
What do you mean by pulling out equity ? How do you do that ?
Thanks as always.
Thanks. I found it myself. Should have googled it first.
For any lazy person reading, this is when you take money out of your existing loan. Usually done when the valuation of your property has increased and you need deposit money for a second property etc
Great blog! Thanks for sharing this information. For first-time home buyers, it is really important to be careful when choosing the right home and buying a property for the right price. You don’t want to spend something that is so expensive and paying a lot of extra fees. I personally think it is good to ask help from professionals to avoid mistakes and doing your own research as well.
Thanks for the great tips for buying property. We’re looking to buy a home, so I’ll have to remember what you said about the 5% rule and the 20% price. That’ll help us figure out our budget.
Nice and informative blog post!!
Another great article. Would you change the way you bought an investment property if you planned to make it your PPOR in the future? Say 5 years after purchase. I’m looking into this now which would mean my current house would then become an investment property. Cheers.
I wouldn’t change anything. Just make sure you have money in an offset and not paying off the principal if you’re planning on turning a PPOR into an investment.
Love your blog mate! I find it quite inspirational. I just have a little comment about the COC calculation. I would argue that the most accurate way to calculate wealth and assess investment options is through expected future cash flows and net present value (NPV) rather than the COC, payback period or return on investment (ROI). An investment with an 18% COC is not always better than one with 14%, so I can’t drive the conclusion that lower deposit is better outright without taking other factors in consideration. Without going into the technicalities, I will use your example to illustrate. If you had the 10% difference in deposit in cash and you opted to pay only 10% rather than 20 % in order to achieve COC 18%, the cash that you kept should be reinvested immediately in an investment that should give you return of more than 5% p.a. (your loan interest), to the duration of your loan in order for your net worth to be better. I hope this makes sense.
Hi AD,
Interesting analysis. I see where you’re coming from.
I don’t spend too much time on analysing investments these days. Most of our investing is pretty passive and hands off (index style). There was a day were I used to loved crunching the numbers through different formula’s but not anymore.
Thanks for the comment mate.
Cheers