All Topics / General Property / The Dangers of Using Equity to Fund Retirement

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  • Profile photo of Steve McKnightSteve McKnight
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    Please use this post to discuss the dangers of using equity to fund retirement as outlined in the June 2005 newsletter.

    The newsletter will be sent out later today.

    Rgeards,

    Steve McKnight

    **********
    Remember that success comes from doing things differently.
    **********

    Steve McKnight | PropertyInvesting.com Pty Ltd | CEO
    https://www.propertyinvesting.com

    Success comes from doing things differently

    Profile photo of Michael WhyteMichael Whyte
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    Steve,

    How about a danger of NOT using equity to fund retirement:

    1. Paying way too much tax on your income. By living off equity you can get away with paying “tax” at the prevailing cost of capital.

    But I recognise that its not for everyone, and that your asset strategy and structure can either be conducive to this or not. You need a “growth” asset structure and not an “income” asset structure for it to be viable and appropriate.

    Cheers,
    Michael.

    Profile photo of maximusmaximus
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    I’d like to get an opinion from everyone on how much you think you would need (in equity) to even consider living on equity. Obviously, this will depend upon your living standards etc, but what sort of built up equity is required?

    Profile photo of Steve McKnightSteve McKnight
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    Hi Michael,

    Your point is well made in that there are advantages and disadvantages of using equity.

    My experience is that the advantages are often given without a full explaination of the risks, hence the newsletter. Also discussed is the deductibility of interest payments in general.

    Maximus, how much money is needed for retirement is a matter for each person depending on their planned lifestyle costs and age when they want to retire.

    A helpful analysis is provided at this link.

    Regards,

    Steve McKnight

    **********
    Remember that success comes from doing things differently.
    **********

    Steve McKnight | PropertyInvesting.com Pty Ltd | CEO
    https://www.propertyinvesting.com

    Success comes from doing things differently

    Profile photo of Robbie BRobbie B
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    I am a little disappointed in the most recent newsletter. It has a lot of very familiar content!

    TMA


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    Profile photo of wizardfromOzwizardfromOz
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    Steve
    By the looks of your comments in the newsletter you really haven’t run the numbers properly to give a balanced view of how to use equity for retirement, you have just used the throw away line to build some hype and stuck together some loose facts to try an prop it up. Maybe if you got someone to help you run the numbers you might give a more balanced view to your readers rather than a silly cooked goose analogy.
    For sure in the scenario where a person only invests in one property and does this just before retirement you are in a pickle, but the same is true if you were trying to rely on a positive cashflow.
    I can’t imagine anyone reading your newsletter would be aiming at anything less than a portfolio of property to retire on over a number of years well before retiring. Given that assumption you must surely realise that with the benefit of great leverage the benefits of capital growth far outweigh paying for the loss of tax deductions in retirement. This is not even factoring in the growth of rent in the portfolio that bring the cashflow back closer to neutral.
    Lets take a quick snapshot, assume over 7 years you have acquired a $1mill portfolio. If your porfolio is growing at 7% (10 year doubling average) then it will grow by $70k say you have to pay $20k to cover the neg cashflow in the portfolio (no tax rebate) and you drew down $50k to live on you have a neutral equity position. Ofcourse you LVR needs to be below 70% hence ensuring that people don’t leave this strategy too late.
    $50k is also post tax dollars so equivalent to $70k if you earned that in rent or other taxable income.
    Because of the size of the asset the growth in equity is going to far outstrip the growth of the non-deductable debt. So why mislead people like this?

    creating wealth with property

    Profile photo of Robbie BRobbie B
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    Wizard, you make it sound sooooo easy!

    You should never assume anything. Many people start investing at retirement age.

    Also, how would your example stand up with a 20% drop in property value for a couple of years and interest rates trending upwards???

    Also, the 10 year doubling average is across the country. Specific areas move up and down. In any case, historical returns do not guarantee future returns.

    TMA


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    Profile photo of gatsbygatsby
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    You made some good points Rob. Also Steve,I thought your inclusion of keeping an ongoing monitored budget (allowing 10% for the unexpected) was an important point.
    Cheers,
    Gatsby.

    “Sometimes the hardest thing to do in life is often the best thing to do.”

    Profile photo of BorgInvestorBorgInvestor
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    I’d be pretty hesitant to employ a strategy of drawing down equity to fund my retirement. I’d like to think that at the end of the day I could live with a comparible lifestyle to my current one, and be able to leave a generous nest egg for my kids.

    Profile photo of Michael WhyteMichael Whyte
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    Borginvestor,

    You miss the point that drawing down equity does not reduce your year ending net equity. The approach is based on drawing equity “in arrears” from the growth in your portfolio. You should never draw more than its growth or you would reduce your net position.

    In fact you should never draw more than growth less CPI indexation so that your true “buying power” of your net equity is preserved over time.

    Overall, living off equity is a relatively simple concept but it is outside the comfort zone of a lot of people. Most people would rather live off surplus “income” from the structure and not surplus “growth”.

    Read that last bit again, its the key point (particularly that word “surplus” in both options)…

    Cheers,
    Michael.

    PS. If someone can tell me how to attach a file then I’ll link a little 20k spreadsheet here which nicely illustrates the impact of the different LOI vs LOE strategies.

    Profile photo of marsdenmarsden
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    The LOE theory relies on the concept that property values will rise by 5% plus indefinitely. While property values have, at least since 1946, responded favourably, they may not continue to rise regularly and steadily. In fact, it appears that we may see a protracted period of no growth and perhaps a decline. Twenty years of little or no growth is very predictable.

    If you try to live off equity from age 65 through a 20 year ‘no growth’ period your LOE hopes will not be effective. You will reach a ripe old age of 85 and will have eaten most of your properties.
    Worst still if you can see interest rate rises in the future!

    Call it doom and gloom if you like but some may need to consider the possibility.

    Profile photo of SeeChangeSeeChange
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    Michael

    For me the problem with Living of Equity is what happens if the unexpected happen ( well maybe not unexpected by some )

    To draw down equity you are assuming that the way the banking system will allow you access to you equity in terms of increasing the equity you can access . I would hate to be at 70 when there’s a recession, prices gone down for a few years ( that does happen :) ) and the banks decide that the latest fade of Living of equity has got them nervous , so they not only decide to revalue all my properties down, but decrease the LVR that they’re prepared to lend me. Interest rates go up so I’m caught in a personal perfect finacial storm.

    I can’t sell because the markets gone to the crapper , and even if I could sell , because I’ve drawn down my available equity , It’s got to the point where all of the funds I’d have available after sale are going to pay for the CGT , which now no longer has a 50 % rebate.

    Also because I’ve been claiming depreciation off all my properties ( and the depreciation you claim is taken of the capital base cost when working out CGT ) , the capital base cost of my properties is lower , so my capital gains tax is even higher.

    I’m stuffed.

    I think there is a place for living off equity , but to use it as a plan for retirement ( unless you’re loaded with a very low LVR ) is too risky.
    To talk about doing it with LVR’s of around 80 % which is suggested by some , leaves no margin for error if there’s a prolonged downturn or change in the playing field. After all we’ve just had the longest boom for a long term , who’s to say we won’t have a prolonged down turn.

    Change in banking practice ? I can remember as a young Doctor a few years ago ( around 1984… sheese …) being knocked back for a loan on an entry level unit in Homebush west , because I hadn’t had the required deposit save up for the preceeding 2 years ( or something like that ). Rolf / Simon where were you then ….:)

    See Change

    Profile photo of Michael WhyteMichael Whyte
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    Originally posted by SeeChange:

    I think there is a place for living off equity , but to use it as a plan for retirement ( unless you’re loaded with a very low LVR ) is too risky.

    See Change,

    I agree. That’s why on the other thread I suggested that “If you find this too risky” then just up your equity assumptions until you’re happy with it. My personal approach would be a hybrid part income and part equity to fund my retirement. That’s option 2 in my spreadsheet (which I don’t know how to attach). The other two options I modelled were “Pure income” and Pure growth” strategies. They only vary by the amount of leverage you employ. Pure income was no leverage, so 100% equity. Mixed income/growth was partial leverage, so 50% equity / 50% borrowings. And Pure growth was maximised leverage at 20% equity / 80% borrowings.

    If you assume the same amount of equity in and the same amount of cash drawn in to your pocket, then the maximum leverage approach delivered the best result for growing your equity. But this assumed 5% rental yields, 7% capital gain and 7.5% loan interest.

    Obviously, if you tinker with these assumptions then the outcome would change.

    The trick is to have enough “income” in your structure such that you don’t have to live off equity growth every year. But you want enough gearing that you can live off the growth in the good years and so pay much less effective tax.

    All just a game of numbers really…

    Michael.

    Profile photo of Robbie BRobbie B
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    I think all the supporters of living off equty are totally missing the point. It must be assumed that to draw down on equity to ‘live on’ (non-deductible) occurs only when the person borrowing ‘NEEDS the extra money’. There is no other reason to do it. I am referring to LIVING off equity and NOT INVESTING off equity. It may also be assumed that these people do not have sufficient income from alternate sources.

    A good example is the current climate. Regardless of how careful anyone has been and only drawing down ‘in arrears’, how does the person who NEEDS money to live get money in times of zero or negative growth???

    Let’s assume they don’t have access to any more funds from anywhere else… the question now turns to how are they supposed to make the repayments on all the borrowings that have been increasing at the rate of equity growth each year when they run out of the last draw down?

    Living off equity is the most ridiculoue thing I have ever heard of for people who actually need the money to live on.

    Investing off equity is much more sensible and generating a healthy ongoing income that will maintain or even increase quality of life is far more beneficial and sustainable with a much lower level of risk!

    TMA


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    Profile photo of dalefreodalefreo
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    I am a perfect example of not using equity to fund your lifestyle/retirement. This year I have sold my home because I could no longer afford my interest bill each month. It was a terribly hard decision to sell my home but in January that is what I did. Then, suddenly the Sydney market collapsed and buyers were extremely scarce. It was one of the worst times of my life – not being able to make my monthly repayments AND no buyers for the property.

    It took me 6 months to sell the property, mostly I had to find the price the new market was ready to pay i.e. drop my price. I sold the house to a buyer who was interested in me being the tennant at a rent rate we agreed upon, allowing me to continue living in the home at half the monthly cost and freeing up my small remaining equity for me to invest elswhere.

    As I wait the final 2 weeks before settlement I am now very happy with how this has turned out. I have learnt a lot and I now have huge peace of mind with the prospect of being debt free in 2 weeks time. But it was a very hard way to learn the lesson and I NEVER want to put myself through that ever again.

    Dale Fairbairn

    Profile photo of Steve McKnightSteve McKnight
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    Hi Dale,

    Thanks for your contribution, and to others too for sharing their ideas.

    The purpose of my newsletter was not saying ‘don’t do it’, but rather, if you do then you need to know the nature of the investment and specifically, the dangers that aren’t always properly explained.

    Thanks for your input too Rob. I’m sorry you wouldn’t rate it as one of my better newsletter efforts, but the goal was to get people thinking so hopefully it does that.

    Thanks again for everyone’s input, especially Wizardfromoz for his/her alternative view.

    Regards,

    Steve McKnight

    **********
    Remember that success comes from doing things differently.
    **********

    Steve McKnight | PropertyInvesting.com Pty Ltd | CEO
    https://www.propertyinvesting.com

    Success comes from doing things differently

    Profile photo of wizardfromOzwizardfromOz
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    Originally posted by TMA:

    Wizard, you make it sound sooooo easy!
    Also, how would your example stand up with a 20% drop in property value for a couple of years and interest rates trending upwards???

    Also, the 10 year doubling average is across the country. Specific areas move up and down. In any case, historical returns do not guarantee future returns.

    I think Michaels comments there are the most balanced I have seen here.
    Let me say I am not trying to convince anyone of anything, I just find it unfortunate that when people preach doom and gloom based on emotions not facts, it scares people off considering real alternatives to an important life skills: wealth creation for retirement.

    Take the quote here, obviously lacking any knowledge of the facts in residential property growth in Australia…The 10 year doubling average is a very conservative figure the more close figure in capital cities is 7 years and of course recently it has been doing far better than that. So look at the median house price growth from REIA over the past 80-90 years you will see the evidence. Ofcourse it doesn’t predict the future, what a nonsensical argument.
    20% drop in value would be a result of poor planning of a portfolio and may happen in some bizzare circumstances but if your LVR is targeted at 50% or lower, you may still have a solution, but i also like Michaels approach of balance with cashflow options. Any smart investor is going to include say Perth, Brisbane and maybe even darwin property in a portfolio to offset situation like is happening in Sydney. Brisbane and perth are still growing while Melb Syd goes backwards.Likewise you wouldn’t invest all your money on one share in the stock market.
    In regards to the question about how people get funds to draw down in periods of zero growth, surely people here have heard of lo-doc loans or asset lends. Farmers have been using this strategy for many years. As michael says if you over spend the growth and CPI rates you will eventually hit the wall, that is why it is important to get your asset base high enough (over 1.3 mill) and give some time to have your LVR get down to a comfortable level. But when doing this base it on facts and numbers not hype and emotion.
    People need to make judgements of the best strategies and long term trends is one of the best fact based methodologies, rather than emotive hype based on dogma.
    Thanks for your interest in my opinion. It is just that.

    creating wealth with property

    Profile photo of wealth4life.comwealth4life.com
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    Recently i have been in discussions with Gaydens Lawyers (Sydney) regarding the new senior living policy (old + 55).

    It is interesting to note that currently 77% of all retirees still live at home with no mortgage and little cash, i mean unhappy and struggling.

    New structures today enable these people to use their equity to survive until death, sad as that may seem.

    I have said many times before on this site that the problem is our financial fundermental education. This situation is going to get worse in the future unless Australians control their spending habbits.

    95% of people live beyond their means, credit card debt over 30bil, interest free store accounts, debt to equity ratios increasing etc etc.

    These forums provide an insight for the minority of people who want to change. But because the majority won’t face the facts we will have to pay for the miserable sods in the future, i know lets increase the taxes on the rich and property investors to fund them!!

    resiwealth

    Profile photo of TerrywTerryw
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    What is the alternative to living off equity?

    It would probably have to be selling a property. If you were to sell a property you will lose all future capital growth of that property and will also have to pay various costs. Surely this is cooking the goose (and not drawing down the capital).

    However, if you were able to keep the property and to use some of the equity, you would also be able to access future capital growth as well.

    This stategy may not suit many people, but it can help other people stop working sooner than expected. On another forum, a person commented that they were able to ‘retire’ from work (before 30) by using this strategy. This freedom from having to attend work everyday enabled them to concentrate on property and they then made more money doing up property in the 1st year than they would have made working for that year.

    Terryw
    Discover Home Loans
    North Sydney
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    Terryw | Structuring Lawyers Pty Ltd / Loan Structuring Pty Ltd
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    Profile photo of SeeChangeSeeChange
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    @seechange
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    Originally posted by Terryw:

    What is the alternative to living off equity?

    It would probably have to be selling a property. If you were to sell a property you will lose all future capital growth of that property and will also have to pay various costs. Surely this is cooking the goose (and not drawing down the capital).

    However, if you were able to keep the property and to use some of the equity, you would also be able to access future capital growth as well.

    This stategy may not suit many people, but it can help other people stop working sooner than expected. On another forum, a person commented that they were able to ‘retire’ from work (before 30) by using this strategy. This freedom from having to attend work everyday enabled them to concentrate on property and they then made more money doing up property in the 1st year than they would have made working for that year.

    Terryw
    Discover Home Loans
    North Sydney
    [email protected]

    I think people need to adopt a more flexible approach to their investing. eg Gear up to high LVR’s when the market is about to take off, then cash up some properties , and lower your LVR when the market is peaking , or has peaked . In my experience the property market moves slowly enough to enable one to do this, though you may have to accept 5-10 % below the peak price when you sell.

    This can give you a smaller but genuinely cash flow positive portfolio, which you can use to fund purchases in the next cycle , and so on.,

    See Change

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