I’m pleased to present our first reader case study on this blog. This is where I encourage you, the readers, to write in with your situation that you want looked at.
I do my best to answer your questions and provide recommendations for your situation. I also encourage you all to post your thoughts in the comments sections to help out our subject.
Today, we have Jim (not his real name) wanting to know what he should do next in order to achieve his goals of marriage, kids and retirement before 60.
I follow your blog and I want your thoughts on my current situation and what you would do if you were in my shoes.
I’m 33 years old with a girlfriend but no kids. I’d like to get married and have kids in the next 3-5 years as long as I am financially ready.
I have been burnt badly in shares. I had $120K at one stage, now only $6,000.
I live in Auckland and own a house. I rent out one room to help with the mortgage and have been able to knock it down in the last 4 years.
I’ve recently started a side hustle in E-Commerce, earning $500 per week.
My plan is to purchase a rental property, but I don’t know if I should do it now or wait until I pay my house off.
My financial situation is:
Main job - $4,700
Secondary job - $2167
Flatmate - $693
Total monthly income - $7,126
Total monthly expenses - $2,537
Total liabilities - $260,000
Investments or savings
Savings $51,000: 3.25% returns
Total assets - $753,000
Net worth - $493,000
Monthly surplus - $4,589
Ultimately, I want freedom and choices later down the track. I know if I put in the hard work now, I want to retire before age 60.
First of all, let me begin by saying congratulations on a great job of your finances so far. A net worth rapidly approaching $500,000 and a monthly cash surplus of $4,500 thanks to some hustling by renting out a room in your house and taking on a second job. This extra income helps make up for a poorly structured investment portfolio. You could be doing even better here, making better use of your money.
You are currently funneling your $4,589 a month cash surplus into your online savings account paying an interest rate of 3.25%. After 28% PIE tax rate has been applied to your savings, your return from your savings is just 2.34%. Yet your mortgage ranges from 4-4.3%. Effectively you are lending your money to the bank for a return of 2.34%, and they are lending your own money back to you at a rate of over 4%. Almost double.
I can see why you are doing this though, as you are thinking about buying a rental property. This money can help with a deposit and you don't want to lock it away into the house.
The problem with buying a rental property now
You have a very kiwi problem of having a lot of your net worth tied up in housing. 75% of your net worth is in housing and just 25% outside of housing. This is a fairly typical allocation for New Zealanders as we love our houses, but it is not very well diversified. What happens if there is a large housing crash? 75% of your net worth will be affected.
If you buy a rental property with your savings then over 80% of your net worth will be in property, exacerbating the problem.
Also, housing in Auckland is currently very expensive. It is hard to find rental properties that have positive cashflow from the beginning in the big cities. It may take many years before your rental property experiences positive cashflow which could put a strain on your finances. Especially if you get married and have children in the next few years. Weddings and children aren’t cheap for most people.
Your portfolio needs more diversification, not less. With the current price of houses in Auckland, it may be years before you see positive cashflow in the rental property. As you get married and have kids, your expenses will increase and cashflow will become critical. With young children you may not be able to continue spend 15 hours a week on a side business either. That’s only a call you can make and what is best for you and the family. Either way, cashflow is important and if your cash is tied up in housing then you won’t be in a good position to be flexible here.
Hold off on buying a rental property for now. You could revisit this idea when your investments are better diversified, houses are more affordable, and your life with marriage and kids is more settled.
So, what to do with your monthly savings?
As mentioned, adding your savings to an online account that is paying you about half of the cost of borrowing that same money does not make any financial sense. Once you have enough in your savings account to cover your emergency needs, then you need to find a better place for that money. If inflation increases, then savings accounts may lose value over time.
You have $4,589 available to invest every month. I see two options and you are probably not going to like my preferred option.
Option one: I think you need to get over your bad experience with the stock market and consider getting back in. By your description you made some bad mistakes. Going from $120K to $6K in a market that has been going upwards for the last 10 years means that your portfolio was not constructed very well. It would have not been diversified well enough, nor risks been minimised. On top of this, I imagine some of your investing behaviours were off. The stock market is a great place for long term returns that outpace inflation. Read my investing series and see if you may be ready to dip your toes in.
Option two: Pay down the mortgage. 4% guaranteed return from paying down the mortgage is pretty good. Much better than the online savings. Better than investing in the stock market? No one knows for sure, but the odds are in favour of stock investing if investing for 15 years or longer. As mortgage rates increase, this option becomes more attractive. Just remember, that once you pay down the mortgage you can’t get that cash back as long as you are keeping the house. With stocks you can more easily turn that into cash if needed.
For a more detailed analysis you can read my pay off mortgage or invest post here.
Time to pop the red pill, we're about to run some math on these options
1/. Paying down the mortgage only (20 year scenario)
Current mortgage - $260,000
Interest rate – 4.2%
Years remaining – 26
Monthly repayments - $1371
Total interest - $167,710
Total interest with extra $4589 per month payments - $56,274
Total savings - $149,635 and 23 years. You could pay off your mortgage in just over 3 years at your current savings rate.
17 years of investment returns post mortgage payoff - $1,646,844 (assumes 6% return after costs)
Total 20 year net worth improvement - $1,796,479 ($1,646,844 + $149,635)
2/. Investing in the stock market only
$4589 per month invested for 20 years - $2,147,251
Total 20 year net worth improvement - $2,147,251
Investing is better than paying off the mortgage by $350,772 in this scenario
3/. Investing in stock market and paying down the mortgage (50/50)
$2294.50 extra per month towards the mortgage – Savings of $128,337 and 19 years
$2294.50 per month invested for 7 years - $244,983
$4589 per month now invested for 13 years post mortgage payoff, with a starting principal of $244,983 from the first 7 years - $1,624,721 returns
Total 20 year net improvement - $1,753,058 ($1,624,721 + $128,337)
Paying off the mortgage is better in this scenario, but investing 100% is better than both.
Given your past, investing 100% in stocks is not an option, even though in many cases it produces the best returns over the long term. That leaves paying down the mortgage, or both paying down the mortgage and investing. In your situation, paying down the mortgage works out the best and is the least risky over 20 years. If however, the stock market returns 7% instead of 6% then that will be better. The stock market returns are unknown, but mortgage repayments are not.
The downside to paying down the mortgage is that even more of your net worth will be in housing. You will not be well diversified and at risk of a large net worth decrease if a housing downturn occurs. By investing and paying down the mortgage you are more diversified with a better spread of risk.
In your scenario though the mortgage would be fully paid off in 3 years which is super quick! That is not too long to wait until you can start investing in other areas outside of housing.
Pay off your mortgage in full with all your surplus cash. Use that 3 year mortgage pay down period to learn more about the stock market, so that when you have paid off the mortgage you are better prepared than last time. It will also be great for peace of mind to have a fully paid for home as you prepare to get married, then have children.
Just make sure that you check with your bank how much extra you can pay on your fixed mortgages without penalty. Then, when the first fixed mortgage comes off term, leave it on floating and attack that with your surplus.
What about financial independence?
Your last query was regarding financial independence. You would like to be retired before 60. With your extremely low level of expenses (not including your mortgage) of $14,000 per year, you could retire with a paid off house and approximately $700,000. I say $700,000 as that is 50 times your expenses or put another way, expenses will be 2% of your total portfolio. This is a low percentage, but one that is needed due to your low tolerance for investing risk.
The good news is with you saving $55,000 per year and your low expenses, is that you don’t have to take risks with the stock market if you don’t want.
With your current level of savings and given your current situation, you could achieve financial independence by age 45. If you were willing to invest 50% in the stock market long term to fund your retirement you could probably retire with approximately $420,000 which equates to 3.3% of your portfolio. A higher percentage due to the likely higher returns could mean you can reach financial independence by age 41, 4 years sooner just by taking on a bit more risk. You have to be comfortable with this though.
However, and its a big however, with marriage and kids you should expect your expenses to increase significantly and your income may drop if you drop your side hustle or your future partner drops their job to care for any children. You will need to calculate your retirement savings needed based on your future level of expenses. Not your current level. You may not know what this number is until you have lived that life for a bit.
It would be wise to reassess your retire early plan after your new lifestyle has solidified, not now.
Buying a rental property will definitely slow this journey down, but you could end up better off many years down the track. It is your call on whether you would prefer financial independence sooner or later what you do here. You can always buy a rental property later in life if you still wanted, but you can't buy back your financial independence.
That is all for this first reader case study. Please chime in on the comments and offer your thoughts for Jim.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here.