Is compound interest the eighth wonder of the world?

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. – Albert Einstein

Finance is leverage in the financial world. Getting the balance right is absolutely crucial when you are growing a property portfolio. Having your portfolio too highly geared leaves you nowhere to go if something goes wrong and conversely not using finance to leverage means you most likely find extremely difficult to build a property portfolio. Compound interest is a double edged sword, as leverage, it can quickly grow a property portfolio or if it is misused it can quickly destroy a property portfolio. A good analogy is a knife, a knife in the hand of a surgeon can be lifesaving, a knife in the hand of a thug can be life threatening. The same for compound interest, as Albert Einstein says he who understands it earns it, he who doesn’t pay for it. Having a good understanding of compound interest will help you use it a leverage tool to grow a property portfolio.

So what is Compound Interest? Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. In the case of a loan, interest is calculated on a daily basis and charged the loan every month. As long as you are paying more than the interest charged each month you will be paying off the principal. Paying more and paying frequently will see the loan term shorter, if you stop paying then you will end up with interest being charged on top of interest and can quickly derail a loan.

A common question that I often get asked is how do I get started borrowing money for an investment property? To start buying your first property requires a deposit. A good number of lenders will lend up to 95% of the property value. There is an additional cost for people who borrow over 80 % of the property value this cost is known as lenders mortgage insurance. If you are borrowing 95% of the value of the property, the mortgage insurance cost will be in the vicinity of about 2.5% – 3.5% of the borrowing cost. Some lenders will capitalise this to the loan which will mean you have effectively borrowed 97.5% – 98.5% of the value of the property.

There are pros and cons. In an upward trending market, it gets you in the property market before the property price escalates again. You may find that paying a mortgage could be similar to paying rent and justifies the mortgage insurance costs. This has rung true in recent times with interest rates being so low. Conversely, in a steady or even downward trending market you will have to work hard at paying down the loan as there is no growth to offset the cost and a bigger risk to manage the mortgage. Borrowing at 95% of the value of the property is a great way for a first time home buyer to enter the market. For most home buyers they look at the first home to get out of the renting cycle, it will either be their forever home or they will use the home to upgrade into something bigger down the track. On the other hand, the property investors goal is to build a property portfolio to create financial freedom. Having too many properties too highly geared will create more way more headaches than freedom.

I would strongly recommend if you are starting out on your property investor journey save at least a 10% deposit plus the cost to complete the deal. I can hear some of the arguments now as I say this, there is a school of thought that you use as much of other people’s money when you invest, so you can get into more properties. The mortgage insurance is just a cost of doing business. My response to this school of thought is to keep the end goal in mind, you want financial freedom not headaches.

Having your personal finances in order is about being a good steward of your money, making sure that you are constantly keeping everything in balance. This includes your leveraging.

Happy investing

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