Throughout our working lives we have a finite earning capacity, our remaining capacity can be reasonably calculated at any point by totalling our number of working hours remaining and adding wages, overtime, bonuses and wage increases.
Factor in tax and inflation and our finite earning capacity is restricted unless income is increasing at, or above, inflation… this also applies to money held in savings.
Understanding the real value of money
Money devalues over time – as the cost of living increases, the value of money decreases. While $100 today will still be $100 tomorrow, your $100 will not buy as much.
Groceries purchased for $100 a year ago now costs $103 for the same groceries. In 15 years’ time the same groceries would potentially cost $156 (at 3% inflation).
The devaluing of money is called inflation, many retirement planners, when discussing retirement income needs, will reference ‘today’s dollars’. A typical conversation…
Planner “How much would you like to retire on today’s dollars?”
Client “about $70,000 p.a.”
Planner ”with 15 years until retirement, assuming 3% inflation, you will need to plan for a retirement income of $109,000 p.a.”
It’s not all doom and gloom though, as money devalues, the value of debt also decreases (more on this below).
Saving vs. Investing
With inflation at 2.1% (Nov 2015) and the average bank savings account paying 1% interest*, the money held in bank accounts is actually decreasing in value.
*Interest earned on savings is also taxed
For money located in high interest savings accounts or term deposits, the interest earned is likely to be exceeding inflation.
Saving $100 a week for 15 years…
Observation: At 7% interest, savings would only reach the second year of retirement at the desired income level.
Compare the difference using $100 a week to cover the shortfall of a leveraged investment such as an investment property.
Contributing $100 a week to a negatively geared investment…
When borrowing to purchase an investment you are securing the investment at today’s value, in today’s dollars. Over time the investment value and investment income increases while the debt value decreases.
Value of Money vs. Value of Investments
It can be hard to get ahead on an income alone when a percentage of income is taxed and the value of money is incrementally decreasing. However putting your income to work acquiring investments that grow in value can improve the performance of your money…
Investments can earn you an income stream (dividends or rental income), which also increases over time. While your earning capacity over a lifetime is limited to the number of working hours you can contribute, investment income is not.
Paying off the mortgage vs. investing
Lets put this into more practical terms – many families with a mortgage will direct their spare income into their mortgage, prioritising debt reduction over other investment opportunities.
This is a sensible tactic. Instead of earning 1% interest from savings, money is saving 4-5%* interest on the mortgage debt, in addition you are not being taxed on interest earned.
*Relevant to your current interest rate
While this is better than 1% interest earned on savings, it is still the same as earning 4 – 5% in a high interest saving account, (3 – 5% higher if you factor in tax savings)
Contributing spare income to investment opportunities
The downside to focusing on debt reduction is missing out on investment income and growth, to illustrate why; here is a comparison of two couples, both with a mortgage.
The first Couple:
Directs their $10,000 annual surplus to reducing their mortgage
The Second Couple:
Purchases a negatively geared property for $460,000
Borrows 100% of the purchase price, plus extra for costs
Directs all surplus cash flow to reducing their mortgage
Financials After 15 Years…
Observation: You can see that after 15 years the two couples owe a similar amount on their home loans. However, Couple Two have benefited from the increase in value in the investment property, without necessarily compromising their goal of reducing their own home loan.
Financials After 25 Years…
Observation: After 25 years both couples have now paid off their home loans and their homes have both increased in value. After paying off their home loan Couple One have started to build up some savings. Couple Two, after paying off their home loan, have now almost completely paid down the investment loan on the investment property. The steady growth in the value of the investment property has put them over a million dollars ahead of Couple One.
Understanding the real value of time
Both of our couples realised that in order to buy their family homes they needed to borrow to do so. Otherwise the continual rise in housing prices would mean that the $750,000 cost of a home would have kept rising more quickly than their ability to ever save that amount.
Couple Two realised that this concept also applies to investments and by establishing an investment property earlier in their lives they would benefit from the time value of money increasing the value of both of their properties.
Of course everyone has different financial circumstances and borrowing to invest may not be suitable for every investor. So we recommend that all investors seek professional advice before commencing such a strategy.
Put your income to work early…
Being in a position to invest early opens the door to further investment opportunities in the future. As property values increase and income increases you can buy again.
Property is one investment option, if you would like to learn more about property investment as a strategy there is an excellent video available here [Click to Continue]
To get a better understanding of how we can help improve the performance of your personal finances then take a look at our 6 step finance advice process [Click to Continue]