What if you had $100,000 (retention benefit or inheritance)? What would you do with it? Most might choose to put it on their mortgage which can be a great idea if you’ve got less than 10 years to run to retirement. Some might take a much-needed holiday or buy a new car. Because you’re here reading this though, you probably already know there’s a better way and that’s to invest it!
So, how would you invest $100,000 towards creating future wealth? Let’s look at the 3 main investing options and their results over a 10-year period to see which one performs best.
Compound growth formula: y = a(1 + r)x
y = value of the variable after x periods (future compounded value)
a = initial value of the variable
r = compound growth rate
x = number of periods
Your first option is to put your money into a savings account or term deposit.
At the time of writing (2017), you’d be lucky to get 3% per annum from one of the main banks. Compounded returns over 10 years at 3% per annum come to $34,392.
So whilst you have technically earned $34,392, you’re barely in front due to the effects of tax and inflation. Putting your money into a savings account is like doing nothing with it! A third of the interest you earn (assuming you’re in the 32.5% or 37% tax bracket) will go to tax. But more importantly, the Australian targeted inflation rate (which is a silent tax) is between 2-3% per annum, so the interest you receive might only just help you keep up with inflation. To stay ahead of inflation, cover tax and actually make a decent return, you’d need to be getting a much higher interest rate.
Your second option is to put your money into shares or a managed fund.
The average return in the Australian stock market tends to be about 8% – one year will be a bit more, the next year will be a bit less, but over a 10-year period you can expect an average of about 7% to 8%.
So, by putting $100,000 into shares for 10 years, increasing at a rate of 8% per year compounded, you’d end up with a portfolio worth around $215,892. So we’ve essentially doubled our investment, which is pretty good, but possibly not the best use of that 10-year period depending on your goals and circumstances.
Property with 80% Mortgage
Your third option could be to purchase a property with an 80% loan and a 20% deposit.
The largest asset you could buy in this situation would be a $400,000 property:
20% deposit: $80,000
Stamp-duty & legals (5%): $20,000
80% loan: $320,000 (No LMI)
So, what would happen to our $400,000 property in 10 years? Trends over the last 50 years show that average 10-year growth in an Australian capital city is around 7% per annum (sometimes more). So at year 10, this property would most likely have a value of $786,860, an increase of over $386,000! Even if we reduce growth to 5% per annum, expected value is $651,557, an increase of over $251,000.
So, after 10 years on an interest-only loan, your expected equity is between $251,000 – $386,000 (more if you were also paying principal). This obviously beats the above returns on the term-deposit and share portfolio scenarios.
Property with 90% Mortgage
Let’s look at a $570,000 purchase at 10% deposit:
10% deposit: $57,000
Stamp-duty & legals (5%): $28,500
90% loan: $513,000
LMI: $14,000 (approx)
After 10 years at 7% growth per annum, expected value is $1,121,276 (growth of $551,276).
At 5% per annum, expected value is $928,469 (growth of $358,469).
At 2% per annum expected value is $694,826 (growth of $124,826) which is still more than the shares example!
The reason we get such an incredible result with property is because we can take our $100,000 investment and use leverage (80-90%) to get a bigger asset at $400,000 or $570,000 using these examples.
Margin lending on shares is usually capped at 60% and you can be called-in (margin call) at any time should share prices fluctuate below their initial purchase price. This legally cannot occur with residential property in Australia.
You also have to consider that our $400,000 newly-built property that rented initially for $380 a week (covering costs), has likely increased its rental rate to around $650-$700 per week and outgrown costs resulting in a passive income!
There are obviously a number of risks that go with property investing, but smart investors understand the law of economic-rent and real-estate cycles, always buy time and never over-extend themselves!