Easing Pain By Sharing Capital Gain

Easing Pain By Sharing Capital Gain

Newcastle Herald
29 March 2007
Noel Whittaker

ROCKETING house prices and soaring rents have created a double whammy for first-home buyers. Their mortgage repayments relative to income are at an all-time high, but saving for a decent deposit is now so much harder because they are paying higher rents.

Consider a young couple earning $40,000 a year each. Tax will take about $7500 each which would leave them with a net combined annual income of $65,000. If we deduct rent of $20,000 a year, and living expenses of $26,000 a year, there is only about $19,000 left over for saving. Even with this healthy surplus, it would still take them two years to save a 10 per cent deposit on a $350,000 home.

To make matters worse, in two years, the price of the house they wish to buy may have increased by more than the amount they have saved.

And of course that is for a frugal pair who don't waste money on huge mobile phone bills, and who have been smart enough to stay away from debt for items like cars that lose value.

Unfortunately, there are still too many in this age bracket who don't have a clue about saving, and spend all they earn.

Over the years, there have been a wide range of government initiatives such as home savings grants and low-interest loans to help young Australians into their first home, but they have often made the problem worse.

In a tight housing market, when you increase the pool of buyers by introducing such initiatives, prices rise further.

Be that as it may, a new equity finance mortgage (EFM), from Adelaide Bank, is worth consideration. It is available to owner-occupiers who can put up a deposit of at least 5 per cent and involves Adelaide Bank providing an interest-free loan of up to 20 per cent of the purchase price of the property in exchange for 40 per cent of the capital gain if the property declines in value, the bank picks up 20 per cent of the loss. The loan is for a maximum of 25 years and the owner is liable for all outgoings such as rates and insurance.

Suppose a couple want to buy a property for $400,000 and have saved a $20,000 deposit. The repayments on a traditional loan of $380,000 are beyond them, but by taking advantage of the EFM, they qualify for an $80,000 interest-free loan from the bank and so have to borrow only $300,000.

If the property is sold in 10 years for $660,000 clear, that's a 5 per cent a year gain; they will receive $237,000 after repaying the interest-free loan of $80,000, the residual balance of $239,000 on their normal loan and after giving the bank $104,000 of the capital gain. The couple who started with just $20,000, have turned it into $237,000 in 10 years. They have also saved $60,000 in interest.

At first glance giving up 40 per cent of the capital gain in exchange for an interest-free loan for 20 per cent of the property value may seem extreme, but when you think about it, it is not so unreasonable. The bank has put itself into a gearing situation of 2:1 so it is going to want to earn at least 8 per cent on its money, because this is about what it could earn on a conventional mortgage with little risk. Therefore, the property has to appreciate by at least 4 per cent per annum for the bank to earn a minimum of 8 per cent on the interest-free loan.

Now I appreciate that property in many areas has done far better than 4 per cent per annum in the last few years, but let's face it, in the long term home prices have to stay in step with average weekly wages, otherwise we would reach a stage where nobody could afford one. In the last three years, average weekly ordinary time earnings (AWOTE) have gone from $948 a week to $1059 a week that's an increase of just 3.7 per cent per annum.

Obviously it is better to keep all the capital gain to yourself if you have the resources to do it, but surely getting a house in partnership with a bank is better than not getting a house at all.

Furthermore, in a flat market the EFM borrower may do better than one with a traditional loan. Just make sure you read the fine print and clearly understand how it all works.

Noel Whittaker is joint managing director of Whittaker Macnaught Pty Ltd, AFSL number 246519. Readers should seek their own expert advice before making financial decisions.

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