Sailing away from stress

Q: This sounds like a dumb question, but I know nothing about finance, and I'd be grateful for your help.

My brother-in-law and his wife have two investment properties, plus their own home. All are mortgaged to the hilt.

He is in a very well-paid job, and they lead a fantastic, high-rolling lifestyle.

Their financial philosophy is to use "other people's money", ie, the bank's, to make money for themselves. Several of my partner's workmates operate along similar lines and he now wants us to have a go at it.

I'm unhappy about this, as I do not like getting into debt. We are ordinary, working-class people.

Currently, our only debt is a $40,000 mortgage on our $300,000 house. We have no credit card or hire purchase debt, a small pension plan and $15,000 rainy-day savings.

I enjoy my lifestyle and am quite content, but am I being dull or over-cautious - as my partner says?

I can't help feeling that my in-laws are living in never-never land. They've just got back from a holiday overseas, which has set my partner off moping over what we could be doing. But I'm not convinced, and would like some solid facts from an expert to back up my argument. Thank you.

A: Your question is far from dumb.

Too many people get enticed into mortgaged investment - often called gearing - without understanding what they're getting into.

Sure, many people who gear heavily are lucky with their timing and get rich. But there are unlucky ones too. And now that inflation is low, there will be more.

As I've said often, gearing makes a good investment better and a bad investment worse.

As long as your investment grows in value, you benefit from the growth not only on your deposit but also on "other people's money".

The trouble comes if the value of the investment has fallen when you have to sell. Even a small decline can wipe out all your equity in a heavily geared investment, and you might also be left with a debt.

You can borrow to invest in anything - provided someone is willing to lend to you - but the vast majority of geared investment is in property.

So let's look at a $300,000 rental property, with a $15,000 (5 per cent) deposit and a $285,000 interest-only mortgage. Most landlords get such mortgages for tax reasons, says James Lockie of mortgage brokers Cairns Lockie.

If the property value has risen 10 per cent, to $330,000, when you sell, you'll have $45,000 after repaying the mortgage. Your $15,000 deposit has tripled. Yippee!

But if the value has fallen just 5 per cent, to $285,000, you'll lose your $15,000. If it falls 10 per cent, to $270,000, you'll owe the lender $15,000.

What if you had an ordinary 25-year principal-and-interest mortgage at a fixed rate of 7.5 per cent? As time goes by, you would then be reducing the loan.

Still, after two years the mortgage would total about $276,600, says Lockie. An 8 per cent drop in house value would more than wipe out your deposit.

Even after five years, the mortgage would total about $261,400. If the house value dropped 13 per cent your deposit would be gone.

Could such falls happen?

Until the late 1980s, when inflation decreased abruptly, prices never fell in New Zealand - at least not in living memory.

Since then, they've fallen only a few per cent in the early 1990s, late 1990s and early this decade. Some landlords got caught then, selling for less than their mortgages because they could no longer cover the shortfall between rent and expenses. But not too many.

What will happen in the next house price trough - widely predicted to be bigger - is anyone's guess.

Those lucky enough to have bought several years ago are unlikely to see prices drop below their purchase price.

More recent buyers should be okay too - as long as they can hang in until prices recover.

But what if they don't have enough income to cope with: mortgage rate increases; declines in rent; unexpected big maintenance bills, or long periods without tenants? All of those are reasonably likely in the current environment.

You don't sound like the kind of person who would happily enter the market at such an iffy time.

Perhaps you can persuade your partner to wait, at least for a while. After all, there might be some pretty good bargains in rental properties over the next few years - by kind courtesy of other landlords who don't make it through the trough.

If you buy when prices have fallen, you'll have a much better chance of joining your rellies on overseas jaunts in the years to come.

But I keep coming back to the fact that you enjoy your lifestyle and are content. Maybe, after watching the plight of those landlords, your partner will also learn to appreciate the security and simplicity of keeping debt low.

Q: Your feeling (granted, somewhat cautionary) that the family in last week's first Q&A should buy a house now has me surprised.

Sure it's almost impossible to pick market tops etc, but by any established criteria, eg, prices to income or prices to rents, current house prices are so dangerously outside norms that correction is only a matter of time.

At the moment this family's rental is at least half paid by the approximately $5500 net earnings she presumably gets from her $100,000 savings.

So her accommodation outgoings would double after buying, then would worsen when the rates, maintenance and insurance bills arrive.

So easy to forget these are part of the "joys" of ownership.

She seems to be coping well on a low income as is.

Buying into the currently overpriced market seems to me a risk she could do without.

A: I thought I was fence-sitting last week, but I suppose I was leaning ever so slightly towards the "buy now" side of the fence. Anyway, you raise some good points.

The trouble is that, while buying now is risky, not buying is also risky.

If house prices continue upwards for a while and then just plateau, which is still quite possible, the woman might lose her chance to buy.

Given that she definitely wants to own her home at some point - which puts her in a different category from the would-be buyers of rental properties in today's first Q&A - there is no low-risk strategy.

Still, your letter is persuasive. I didn't get the impression the woman is using the return on her savings for rent, but if she is, it would indeed be hard to do without that money.

And I agree with you about rates, maintenance and insurance.

I should have given more thought to that.

Unless she expects her income to rise soon, she will surely struggle to cover those expenses on her low income.

All in all, then, perhaps she should wait and hope for a house price plunge.

Then she could put only part of her savings, plus a mortgage, into a house and use the rest of the savings to cover ongoing house expenses until she's in a position to raise her income.