Smeagol – The Prequel
So last week we had many comments on both sides of the story – debate is good, gets the brain cells working.
I was asked by a few to put together a plan for those who had already gone down the path of getting married and having children young. Don’t worry, my Blog has not gone all Lord of the Rings on you… it just seemed appropriate.
Long before Gollum was possessed by the ring, he was known as Smeagol. A happy chap on a modest income who fell in love with a women named Lenora.
This is their story…
Now both Smeagol and Lenora had a passion to create wealth through investing in property and purchased a home firstly, as this was the done thing in their village. Several years later they decided to have children. Obviously this meant the Lenora had to have some time off work to raise the children. This made sense to Smeagol, who was a jeweller of course, as he was on a higher income than Lenora before becoming pregnant.
Now back on one income and with a home mortgage of $320,000, their home was currently worth $480,000.
After doing a budget, a little belt tightening, they worked out they could afford an investment property, but it would have to be a property less than $300,000 where the rent would cover almost all of their loan repayments or only be a little short.
So what do they do here?… what’s their Game Plan?… I personally invest in property at the right price bracket so I can have a lifestyle now and an even better one down the track. Now as common sense as that sounds, very little investors do this…
So as a Game Plan: Smeagol and Lenora need to buy and sell often. See, as they don’t have two incomes and Smeagol is on a modest but not high income, to get that $320,000 home loan down they need to buy and sell.
You see, their home loan repayment is $1,877 per month @ 5.8%. This repayment figure is made up of Principle and interest… but how much of each…???
Well each month they repay $1,877 they are only repaying $331 in Principle… Yep that’s all!
So after their first months repayment, their loan amount reduced from $320,000 to $319, 669.
Yeah it’s kinda depressing isn’t it?
So this is my point… that’s why they need to buy and sell… and more often than others as they are on one income. That way they can sell their investment property when the house has increased in value and pay lump sums onto their home loan to free up cash flow and make a dent into their home loan. This increases their equity position as well.
Now I can already hear some of you saying “why not keep the property as it is cash flow positive and the extra cash could help repay the loan down”… and “what about all the fees in buying and selling real estate?”…
I ask, is the Game Plan to save on fees or pay off your home loan?
Let’s tackle the cash flow positive argument first: Yes if the property is cash flow positive it could help you repay your home loan off faster, but by how much really??? $20 per week… or even $50 per week… whoopee!!!
That’s a whole extra $2,600 per annum from a $320,000 home loan…
If experience tells me anything, this extra money made goes towards holidays and living expenses, not extra loan repayments.
As they are on one income and intend to stay that way for at least 5 years, I would suggest they buy and sell frequently… once the house has increased by say $50,000… sell it and pay down the home loan.
Now your home loan won’t be reduced by $50,000 as there was Stamp Duty and real estate sales commissions to pay along with very minimal Capital gains Tax (especially if Lenora owns 99% and Smeagol 1%) but the number would be around $30,000 – $35,000.
The advantage here is that your home loan balance and repayments have reduced, freeing up cash flow to go back out and buy 2 investment properties. There is some loan re jigging that must happen to re structure the loans correctly again here, but that doesn’t take long.
It also is very motivating to SLAM 35 large onto your home loan in one go… you will be inspired to go again.
Repeat that step again and sell both after $50,000 increase and now your home loan would be $195,000 (including around $20,000 worth of repayments you would have made yourself).
Now that cash flow has increased… and Lenora is working again part time. Affordability and availability in your home equity allows you to invest in four properties now. The key is to buy one at a time… slowly get used to the new level of debt that each investment property brings before buying again…
A key factor in this Game Plan is not selling and upgrading your home… some small renovations yes, but every time you upgrade you get a bigger home loan and endure significant costs. Some investors fall into this trap as well… make some money and then go spend it… stick to the Game Plan!
If you go through the process on 4 investment properties, when you sell these you would be close to owning your home outright.
Upgrade then if this is what you want to do… but if you do, then you will have a home loan again then and must repeat process above.
Now your strategy changes from a Buy and Sell, to a Buy and Hold for now.
As you own your home, you now have no loan repayments to make and have plenty of spare cash to go back out now and invest to create a passive income and create your retirement fund. Same as before, you buy one property at a time and start building the portfolio. There is no reason that 8 or ten properties would be out of the question. This will take a little time but very achievable.
Now you have 10 properties and over $3 million in debt you sit back and relax and let the rents increase, creating a passive income for you both… but don’t stop making extra repayments and paying down the investment debt.
At some stage you will want to slow up work and this is when the selling comes back into the equation… as your properties have been growing in value for probably 10- 15 years you have built some pretty impressive equity in them along with your home. Now you need to work out which ones and how many of those investment properties you need to sell to repay all of the investment debt.
Even if you had to sell 5 out of ten properties, you would be left with 5 properties unencumbered that would be bringing in around $600 per week + each = $3,000 per week.
Not a bad passive income to retire on…
Now everyone’s position is different but this gives you a good understanding of how sensible investing on a modest income can be achieved…