Pay off the mortgage or buy a rental?

It’s a great feeling to have extra money left over at the end of each month. When it’s time to put that money to work for you, the question many kiwis ask themselves is this: should I pay off my mortgage more quickly or buy a rental property? While debt repayment is safe, a rental could be seriously profitable.

What should you do?

Everyone’s situation is different, but you can start to think about the possibilities by asking yourself seven questions:

1. What are your goals for retirement?

Before you can decide what path to take with your money, you need to think about the destination you’d like to reach. Think about how much you’ll need in your retirement, how much you’re on track to have, and how to make up any shortfall. This information will help you understand why you need to make changes now and how powerful your efforts could be, says Hannah McQueen, director of Enable Me.

“Knowing the retirement shortfall gives people something to think about. What will get them the retirement they want? What are the options? They can work longer, spend less, or earn more, but they may be constrained by their jobs. To invest in a business or shares they have to have cash. For a lot of kiwis they’re left with borrowing against their home to invest in something that goes up in value more than it’s costing. But just because everyone’s hopping on the bandwagon, doesn’t mean it’s right for you,” McQueen adds. “Your situation may mean you’re going to have enough [money in retirement] without that. Your plan always has to be connected to the end game.”

2. How long will it be before you need the money?

If you are within 10 years of retirement, you don’t have enough time to get the most from a rental property, says McQueen. In order to make rental property investment less risky and more profitable, you need to own your rental for at least one ‘property cycle’, which is a minimum of eight years but can be as long as 15. Once you’ve owned a property for 15 years, it will almost certainly be worth more than you paid for it, the mortgage will be smaller and your rent should have increased enough to cover the repayments. This is a fantastic position to be in and gives you a high-value asset to help fund your future.

3. What’s your appetite for risk?

“You’re better paying down the mortgage when you’re very risk averse,” says Gavin Busch, certified financial planner and authorised financial adviser, of NZ Financial Planners. “The majority of people believe their risk tolerance is higher than it actually is. They think they can cope when their investment goes down by 10%, but then they panic because the reality can sometimes feel different. If you can sleep at night knowing your investment is worth 10% less, your risk capacity may be a little higher.”

Repaying debt is a zero risk strategy that is guaranteed to benefit your financial position and effectively pays you a rate equivalent to your home loan interest rate. If you would prefer this risk-free approach, you may be better to pay down your home loan completely before venturing into investment. But if you can ignore the headlines about the property market, you may be able to build greater long-term wealth through rental property.

4. How high is your current home loan interest rate?

Are you still fixed in a five-year mortgage at an interest rate of 6% or 7%? If you’re in this situation, concentrate on paying down debt, says Busch: “You’d be wanting to pay off that high cost debt as soon as you can and this is a great time to be repaying.”

Once you are out of your fixed term and able to refinance at a lower rate, you can consider ways to allocate your additional cash.

5. Do you understand what’s involved in being a landlord?

The right advice and set-up can help you minimise the risks, but buying a rental property still involves a certain amount of research, hard work and potential downsides. You can employ experts to help you find, negotiate, tenant and manage your properties – but all at a cost.

“A lot of my clients kind of want to buy a rental but don’t want to get it wrong,” says McQueen. “At some level we all know interest rates will go up, immigration will drop and there will be a correction – it’s not as easy as buying as any old property. If you can’t de-risk, understand what your risks are.”

Rental properties tend to be New Zealanders’ favourite investment, largely because it’s so easy to borrow against our homes and leverage our way into more property. But following the crowd isn’t always a winning strategy when it comes to money. A rental property can be time-consuming, expensive and stressful when things go wrong; there’s the potential to make a lot of money but it’s not as easy as sitting back and watching the equity pile up.

6. Can you do both?

You might be surprised at the money a financial planner can find for you, without having a negative impact on your lifestyle. McQueen says for most of her clients this means refinancing and restructuring loans, checking they’re not paying too much tax (especially small business owners), and tweaking their spending habits.

“In most situations you should be able to do both – if you buy the right type of [rental] property it doesn’t need to compromise your mortgage repayments.” By buying a property where the rent covers the mortgage repayments, for instance, or one where the amount you need to top up every month is not large and you can make some adjustments to your spending that let you comfortably pay that extra cost.

Cashflow is the deciding factor, says Busch: “Within any market there will be ups and downs, how you weather them and whether you survive them depends on your cashflow. A lot of people see their mortgages as their emergency fund, but do have some funds separately as a contingency.”

7. Have you talked to an advisor?

The right advice can help you get your finances on track and help to balance out your risks: “You could start by having a look at sorted.co.nz,” says Busch, “and a good financial adviser should be able to give you some impartial clear advice on your holistic situation, by looking at everything and understanding how it all fits together."