Should I pay my own Home off First, before my Rentals?- article by Graeme Fowler
This is a question that comes up at times when talking to other investors about property investing and the debate about Principal & Interest (P & I) vs Interest Only loans.
Logically and financially it makes more sense to pay your own home off first and as soon as possible, while having your rental property loans on interest only. The reason being you can claim interest as an expense for tax on a rental property, but not on your own home. So why would you want to pay off any principal on your investment property loans while still having a mortgage on your own home, if you’re not able to claim that interest? It makes sense from a financial perspective and because of this, investors will often begin this way with their investing. I used to talk about this with other investors 15 years ago and more. Even though at the time they all intended to pay their own home loan off first and then pay the debt on their rentals, this has still not yet happened. Accountants also will often advise investors to pay their own home loan off first, before paying any principal off their rental properties.
However there are several reasons why I don’t believe this is the best way to invest; even though logic, common sense and most accountants and other investors will tell you different.
Why do I think it’s not such a great idea to do this? Here are some of my reasons for paying both your own home loan and your investment properties down on P & I right from the start.
1) Habits.
People have thoughts, they have ideas and then they take action based on these. Over time, these ideas and thoughts form habits and over a long period of time, these habits create futures. If people start out investing this way i.e. having their own home on P & I (or a revolving credit) and their rental properties are all on interest only, they are very unlikely to change this way of doing things later on – even if they do pay off their own home. They create the habit of having their rental properties on interest only, and if the market has been kind to them (prices going up in value) they will be even more convinced that doing this is the best thing to do as they are gaining equity.
The problem with this is – how many people do you know who have no mortgage on their own home? I know a few people, but really not that many. Up until a short while ago I had no mortgage on the home I was living in, but two years ago my partner and I bought a bigger and a lot more expensive home together, and this home does have a mortgage on it.
In my new book in one of the sections in there, I wrote about the way that many people pay such a huge amount of interest over 35 years or more on their own home, because of the way in which they finance it. People generally change houses every 5 – 7 years and the way they go about financing each new property costs them a huge amount of interest. This is the main reason why a lot of people still have mortgages on their own homes when they retire.
So the theory that people should pay off their own home first before paying down any principal on their rentals in theory may sound like a good idea, but circumstances often do change in our lives and so it’s not always possible to simply have one plan and stick to it forever.
2) Discipline.
Paying down principal on your rental properties at the same time as paying off your own home loan is kind of like a forced discipline. What I mean is, your mortgages get paid down each month on a P & I loan automatically. People will often say to me something like ‘it’s okay, I intend to pay principal off my loans as I have spare money available to do that’. Sometimes they will and sometimes they won’t; but by having the loans on P & I, it’s all done automatically for you each and every month. You don’t need to have the discipline to save money in other areas in order to pay down principal when spare money is available. And that brings me to the next reason.
3) Spending Habits.
When I was an employer for 10 years between 2002 and 2012, as a business owner I had quite a number of employees over that time. The business was a Mr Rental franchise and we rented out home appliances such as TVs, washing machines & fridges, as well as fitness gear, furniture and computers etc to all of our customers. As an incentive to my employees, each time we reached another 100 units that were rented out, I would give them another pay rise. It was only something like $10 - $15 a week or so each time, but what I noticed that whenever they did get a pay rise, they never had that extra money to spare, or to save the following week. Each time, they would have something else to spend it on which was to them, vitally important. It was really interesting asking them all a week or two after each pay rise what they had done with the extra money. At times they had forgotten they had been getting extra money, or they really had no idea what had happened to the extra amount they were getting. They often would say that with their next pay rise though, that they would start saving it. But it just didn’t happen.
People tend to spend up to the amount they earn. Not a lot of people have money left over each week that they save, unless they are really being disciplined to save for something specific, like a deposit for their first home for example.
So, whether you use interest only or P & I loans, most people tend to spend the amount of money that they have available to them each week. This is really an important point to realise. When you’re paying P & I, it’s like a forced saving and over time you don’t miss that extra amount that you could have had available to spend, if you had been using I/O (which would have given you a little bit more cash-flow each month). It becomes your normal amount you have each week, and just like my employees who would have survived just fine if they hadn’t received each and every pay rise they got, so will you. If you still have some doubts that you won’t have enough money to pay P & I on your loans, this brings me to the next point.
4) Extra Income.
You may be thinking that whatever you do with the income that you have right now, there really isn’t enough money to pay anything towards principal. Everyone else may be able to do that, but not me. What I’ve found is that - just like when people get a pay rise and they spend it all and have no idea where it went; when you have extra expenses or costs, you tend to create a way to pay for it. I could give you lots of examples of this that have happened to me over the years, one of these was when I was selling real estate in the 1990’s in Wellington. At the time, I had been selling real estate for less than 12 months and during the first six months I had only made $6,000 or so. The next few months started to get a little better, but still not that wonderful. Then I took a brand new Subaru WRX Impreza for a text drive after seeing a write up about them in the weekly car parade that comes out with the weekend paper. It was a brand new model which had just been released and sounded amazing by the write up in the paper. I took one for a drive, not ever thinking that I would buy one as they were $57,000. At the time, this was a huge amount of money for me and not an amount I would want to spend on any vehicle. After driving it though, I fell in love with the car and just had to have one! It was the most amazing car I had ever driven; it was fast, it handled incredibly well, it looked awesome and was way ahead of anything else at the time. I really, really wanted one and so I ordered a brand new dark green WRX Impreza. It would take about two months to arrive into NZ and I counted down the days before I got it. They were only bringing in eight new cars into the country at that time, there were a few imported ones from Japan starting to come into the country at the time, but I wanted a NZ new one. The deal was that I would have to pay 1/3, 1/3, 1/3 over the next three years. This was $19,000 each year. At the time, even though my network marketing business was still bringing me in some income to live on, my income from real estate was still very low. I knew for this to work I would have to start making a lot more money selling real estate to pay for this car! I became a better real estate sales person. I started running seminars in the evening on property investing even though at the time I had only two rental properties of my own. One of these I eventually sold for a loss of $40,000 and the other one I only just broke even on it after owning it for 4 years. I also studied marketing, especially how to be good at marketing when it came to selling real estate. Within the next 12 months I made $60,000 with my real estate sales, and the following two years earned well over $100,000 each year which was the highest income in our office out of 14 sales people. I became one of the highest income earners in the Wellington region. It doesn’t seem like a lot of money now, but at that time many properties were selling for less than $100,000 and the average sales person was only earning between $20,000 and $40,000 a year. In today’s terms, earning $100,000 would have been the equivalent of earning around $400,000 - $500,000 a year.
By buying this new car, it had helped me in a lot more ways than I could have imagined. My mind expanded to start thinking bigger and I soon started earning more. I focused on the investor market and I also focused on marketing well to get more listings, usually having an average of 18 – 20 listings at any one time when most of the sales people had between one and five listings. I became more creative in many ways and it also helped me to become a better property investor by teaching it, even though I knew very little about investing myself at that time.
I ended up keeping that car for 12 years and only sold it when it was going to cost me more money to repair it that what is was worth. The water pump had failed and the car lost all its water and severely over-heated damaging the engine. The car had done 268,000 kms and I still really enjoyed driving it right up until the time I sold it.
So, I relate this ‘creating income story when I needed it’ a lot to how I think of P & I loans. That is, by having to pay the extra money each month to pay down principal, you may find that you become more creative or think of new ways to earn extra income for yourself to help pay this extra amount each month. My philosophy for a long time has been ‘if you can’t afford to buy this rental property on a 25 year or less P & I loan, then you probably shouldn’t be buying it’.
5) Values.
Properties generally tend to go up in value over time, but at times they also drop in value. Between 2006 and 2013, prices dropped in Hawkes Bay by around 25- 30% in many instances and a lot of investors didn’t like it. If my loans had been on interest only during this time, I would have owed more money on some of them than what they were now worth. It would have been very demoralising and I may have even lost interest in property as well and sold them. Many investors do this as they get discouraged when prices drop. About half the properties I bought in 2014 that I talked about in detail in my recent book (when I bought 20 rental properties in that year), were from investors that had bought their properties at a high. They financed them on interest only when they bought them and now were selling at a huge loss and still had the same debt owing on them as when they had bought the properties. Properties investors had paid $180,000 - $195,000 around 2005 – 2007 and now I was buying them 7 or 8 years later for $120,000 - $145,000.
6) Change of Rules.
Banks can change their rules at any time and that is even more apparent over the last few months. The Reserve bank recently changed their policy with the new 40% deposit rule for investment properties and the banks started implementing this well before they were actually asked to. Since then, some banks have become even more strict with their lending criteria, also the way in which they do things. Interest rates have been all over the place and at times sometimes changing weekly up or down with their fixed term rates and nobody seems to have any idea why.
One policy that has been looked at again recently is the way in which I/O loans are looked at. Most of these loans are used for rental properties but some people also have interest only loans on their own home they live in which to me is just plain madness. Up until now, investors could easily roll these loans over for five year periods at a time with no issues at all. Some interest only loans have been going for 25 years or more now, investors just rolling them over each time. Now banks are looking more seriously at how long they are comfortable with having their clients use interest only loans for. If for example they made a new rule that you weren’t able to take out any loan on interest only and any existing loans had to go onto P & I when they came off their fixed terms, how would that affect things with investors? I’m not saying it will happen, but there’s always a possibility that if it did happen with say another GFC or similar event. A lot of investors would seriously be in a lot of trouble, especially if they are fairly highly geared and cash-flow is already tight for them.
In summary, these are the main reasons why I think it’s always best to pay both your own home loan and your rental properties on P & I loans right from the start. If you do have spare money available from time to time, pay it down on your home loan to reduce the term of the loan as it makes financial sense to. As mentioned, the interest you pay on your home loan is not tax deductible. So you want to pay it off as quickly as you can and therefore minimise the total amount interest that you pay, but still having your investment property loans on P & I loans of no more than 25 years.