The thought police are after us to pay off our debts. Most of the time this makes sense but not if your borrowings are making you money.Borrowing is bad! Say the thought police, as a House of Commons Committee lambasts credit card companies and the Office of Fair Trading investigates the way banks sell personal loans and insurance.
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But while it makes perfect sense to pay off overdrafts or credit card debts on which you’re paying interest at 12% or more, it doesn’t necessarily make sense to pay off debt on which you pay only 5% interest.
Borrowing can boost your wealth
Say you were living in a house worth £100,000 five years ago with a £50,000 mortgage. You could have stayed there, in which case your home would now be worth £200,000 and your equity would be worth £150,000.But because you could afford it, you sold your house for £100,000, increased your mortgage from £50,000 to £100,000 and bought a house worth £150,000. That house is now worth £300,000, and your equity is worth £200,000. Borrowing an extra £50,000 made you a profit of £50,000.
The key question you have to ask is: could I make more than (say) 5% on the money? A lot of people have decided that they can, so they have remortgaged their homes and raised more debt in order to buy more property, often abroad.
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Taking on an investment property is different
But is buying an second property for investment purposes just like buying your own home all over again? No it isn’t, because your home is where you live and any other property will be purely an investment. For this reason, the questions you need to ask are also different.
Before buying a home, these are the financial questions you need to answer:
- Is my job secure or am I completely confident that I can get an equivalent job so I can keep up the payments on a bigger mortgage?
- Am I happy to be in this house for at least five years?
- Does it seem likely that interest rates will rise significantly in the foreseeable future? (Even if your own mortgage is at a fixed rate, a rise in interest rates will eventually stall the housing market).
- Am I confident that the economy will remain reasonably strong for the foreseeable future? (In a recession, house prices are virtually guaranteed to fall).
- Am I confident that the property and its location will continue to be desirable for years to come?
Now suppose you are thinking about remortgaging your home - as all those TV shows encourage you to do - to buy a property in Marrakech or Bulgaria, do it up and make a packet. This time the questions get tougher:
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Could you afford the mortgage payments without any income from the property?
If your answer to this question is: ‘It can’t go wrong’, then you probably shouldn’t be doing it. There are always risks in property speculation - for speculation is what this is - and just because ‘Everyone is doing it’ doesn’t mean it makes sense: ask people who bought tech shares in 1999 and lost 90% of their money!
If your answer is ‘No’, you are putting your family’s security at risk, so you had better ensure they are 100% with you on the adventure - if they aren’t and it does go wrong, they will be quite right to heap the blame on you. And look for ways of limiting the downside.
Will you get an income at least 20% higher than the mortgage payments?
This is a standard buy-to-let measure, which allows for the fact that you won’t get rent every week of the year and you also have to allow for the costs of management and maintenance. If the answer is ‘No’, then refer back to the first question. Make sure your rental figures are realistic, by which I mean not supplied by an agent but verified by you personally from the actual rents being paid for equivalent properties.
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Will the property and its location continue to attract potential visitors/buyers?
The availability of cheap flights in itself is not a sufficient reason to be confident. Lots of people may visit for a weekend but will they want to come back and stay longer? As far as I’m concerned a weekend in Marrakech goes a long way to satisfying exotic needs and I don’t want to spend a week there.
European cities like Paris, Barcelona, Prague, St Petersburg and Florence have cultural attractions that will go on pulling people there for hundreds of years. What has your chosen destination got? Sea, sand and views are pretty much commodities whose value is unlikely to increase.
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Are you buying a ‘fixer-upper’? Can you manage the work and the budget?
Overconfidence on this issue has been the undoing of many a speculator. That and imposing your own taste on a makeover when it is the taste of potential visitors and buyers you need to appeal to. Language and differences in local regulations are both potential traps. Always pay for good independent legal advice on title and regulations.
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Would you be happy to own the property for five years or more?
If your answer is ‘No’, then be realistic: quick sales in a tanking property market only happen at big discounts. If the market turns sour and you want out, you might only be able to get out at a loss.
If this all sounds a bit negative, remember that while property can make you money there is always the risk of loss. It’s easy to get enthusiastic, but if you don’t have good answers for these questions then you have not done enough homework to move the project from being a risky speculation to being a sound investment.
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