The case:Andrew, Brian and Chris have been best friends since kindergarten. Now in their 40s–only months apart in age–they continue their tradition of doing everything together. Despite their similarities, when it comes to money and investing their approaches couldn't be more different.
Andrew is very conservative. He prefers to save his money and then purchase the things he needs. If he uses debt it would be to a minimum and only if absolutely necessary.
Chris, on the other hand, has no problem with borrowing other people's money. His philosophy: if you have to grow you must owe. He also takes more risk than the other two and is open to any investment opportunity.
Brian, the peacemaker, is the one who always finds the middle ground. He often takes advice from both his friends and blends it into his own.
The friends are considering buying into a property development that has recently completed several houses of varying sizes. There are three-bedroom flat houses costing $900,000 and some three-bedroom two-storey units costing $1,800,000.
As for Andrew, he just wants to get a roof over his head at the lowest possible cost. Chris wants the biggest or best and plans to purchase the two-storey unit, modify it to create an apartment downstairs, which he will rent for $3,750. Hearing the plans of the others, Brian has decided to purchase the same unit as Chris but prefers not to have strangers living in his personal space.
The building lots do not come with any perimeter walls or fences and the developer will add $50,000 to the price to cover the cost of construction. Chris says he is not going to waste money putting up a fence but has, instead, negotiated with the company to create the separation between the floors.
The friends all deal with the same banker who is willing to provide 90 per cent financing at 5 per cent per annum over a period of 20 years.
Andrew believes that his low-cost, low-debt strategy would put him ahead of the others. Andrew plans to set aside the difference between his monthly mortgage payment and that of his friends into a credit union account for ten years, which earns a dividend of 5 per cent per annum.
Chris says that he will still be better off even if he pays his mortgage out of pocket and banks the rent money of $3,750 per month into a zero interest account. The friends estimate that the value of properties in the area should appreciate by at least 5 per cent every year.
Nick's Assessment and Advice
The rent effect
If rent were not part of the discussion then Chris and Brian should be in almost the same financial position in ten years. The only difference between their properties is that Brian would have a fence and Chris an extra living space, both valued at $50,000 each.
Including the rental income Chris would be ahead of the others by the amount of extra money he would have collected ($3,750 x 12months x 10 years = $450,000). Rather than waiting ten years to prove a point to Andrew, Chris could invest the rent in the same credit union or make extra payments towards his mortgage. If he chose the credit union option, he should have a future value of $582,309 after ten years (assuming 5 per cent annually compounded monthly).
Now, if instead he chose to dump the rent directly unto the principal of his $1,620,000 ($1,800,000 x 90%), 5 per cent APR mortgage (assuming no penalties), the balance would be reduced to $425,568 in ten years time instead of the projected amortised balance of $1,007,877, that's a difference of $582,309, which is the same figure that he would have if it were saved in the credit union.
Bigger house more wealth?
The two-storey house has a price tag of twice that of the flat house: $1,800,000 and $900,000 respectively.
Obviously if both were appreciating in value at the same rate of 5% per annum then the future value in ten years time would also be $2,964,617 and $1,482,309 respectively–again a two to one (2:1) ratio. At the end of ten years Brian and Chris would have achieved more wealth or equity in their homes than Andrew would have in his. This same ratio of two to one (2:1) also applies to the respective mortgages: Brian and Chris' mortgages would be $1,620,000 whilst Andrew's mortgage would be $810,000.
In ten years time the amortised balances would be $1,007,877 and $503,939 respectively � also two to one (2:1).
Andrew's plan is to save the difference between his monthly mortgage payment of $5,346 and that of his friends $10,692 ($10,692 - $5,346 = $5,346). If Andrew invests this money at 5 per cent per annum (compounded monthly) he would have a future value of $830,139, but to have a truly fair comparison, Andrew would have to put out the difference in down payments as well.
Remember the down payments on each house is 10 per cent and if Brian and Chris paid $180,000 each then Andrew only had to put out half of that: $90,000, which means that he should have the extra $90,000 to invest in the credit union. With a present value of $90,000 and monthly savings of $5,346 Andrew would then have a future value of $978,370.
Even though Andrew's projected property value is half that of his friends, part of his wealth will be stored up in another instrument that appreciates at the same rate of 5 per cent per annum. Both Andrew and Brian (and Chris if rent were not considered) would have the same net worth of $1,956,740 even though the composition of their assets and liabilities are different.
Final comment
This case may seem a bit elementary but the key observation is that if each friend is adding to their respective wealth portfolios at the same monthly rate in instruments that have the same return profiles (annual rates and frequencies of compounding), then the future values would be the same regardless if one owned a bigger house or paid a larger mortgage installment than the other.
Nicholas Dean (CertFa) is a qualified independent financial adviser and is the managing director of The Financial Coaching Centre Ltd. If you have any questions or need advice on today's subject please email: nickadvice@gmail.com or visit website: www.FinancialCoachingCentre.com