Find Financial Freedom

By taking a quick look at the Big Mac Index courtesy of The Economist, it would seem that Thailand is the cheapest place to retire to. Of course, some people’s tastes may have graduated beyond that of a Big Mac and fries by the time they reach retirement age, so with this in mind, what other factors should one look at when searching for a cheap place to retire to?

Cost of property

I’m sure some people from over in Scandinavia may well look at the Big Mac Index and think that retiring to the UK would be cheaper, given how much cheaper the Big Mac is over here than over in say Sweden. But if they did this without considering the cost of housing, then they would be in for a nasty shock, as the UK has some of the most expensive housing in the world. If you want to retire abroad, to somewhere cheaper, then do some research into the price of property. You may well be pleasantly surprised to find that you can sell your fairly average four bedroom detached house in the UK and buy a lovely five or six bedroom palace with a swimming pool in a country with a nice sunny climate!

Cost of living

Clearly the Big Mac Index is not sufficient to make a proper decision on, to do this you will need to consider what the local costs are for groceries, utilities, taxes, petrol (assuming you will run a car), insurance and health care. As well as this, you will need to consider the impact of flying back to the UK every six months or so to visit relatives and/or friends.

Social cost

If you retire abroad, you may struggle with the language – especially if it’s somewhere exotic like Thailand – and it may be too difficult to learn. In addition to this, there may not be a large population of ex-pats, especially British ex-pats, so your social life may well take a hit. And unlike working abroad, you may not get the opportunities to meet lots of new people and therefore make new friends that easily.

Cheap Countries

I haven’t done much research into this, but if I were to, I would be looking at places that are still fairly backward compared to the UK. Think backpacking and gap years, as these places tend to be cheap enough that you can exist for less than £500 a month and still have a bloody good time.

For instance, South America, South East Asia, South Africa, Australia and New Zealand are all popular back-packing destinations, so why not consider these as an ideal cheap place to retire to.

Early retirement is still a concept in use today, primarily to describe the ability to retire before the standard retirement age of 65 in the UK, though these days people tend to talk more about financial freedom as opposed to saying they want to take early retirement.

If you are looking to achieve financial freedom or take early retirement, then you will need to do some planning, it won’t just happen otherwise. First thing that you need to do is set yourself a goal. When I used to work as a mortgage broker, I was lucky enough to receive some good advice from fellow financial advisors about how to help clients get the most out of their financial planning. The technique that was passed onto me is called “The Broad Concept”.

Apparently it is a strategy planning tool that was first conceived during the Vietname war by the Americans. The idea being that if you want to achieve a set of objectives, you must first follow these four simple steps:

1. Work out what objective you want to achieve, or work out your retirement goals.
2. Work out where you are now (with respect to achieving your stated goals).
3. Work out all the various different ways you can achieve your goals.
4. Lastly, analyse and decide upon the best way to achieve your goal by discounting each route in turn.

So how does this work in practice?

Well, the first thing to do is work out step 1. For example, let’s say your objective is to retire at age 50 with an income (in today’s terms) of £25,000 a year.

The next thing to do is work out step2, where you are now (in relation to achieving that goal). So for example, if you are 25 years old and you have no retirement planning, you have 25 years to acquire £500,000 (£25,000/5%) - I’ve assumed a fairly typical 5% return on investment. Clearly this example doesn’t take into account inflation, so to do this correctly, you would have to tweak to allow for the impact of inflation etc.

The third part is the bit where you can have a little bit of fun! Step 3 you need to work out the various different ways to achieve the stated goal of acquiring a pot of £500,000 in 25 years. You could work out that if you invested a few thousand pounds each year into a pension fund, you would achieve the goal. 

You could also look at investing some money into property, with the intention being that in 25 years, the capital appreciation, as well as the mortgage being paid off could provide you with the amount of capital required to retire on. Though, I would potentially just look at investing in property with the intention of holding onto it for the income that it would generate. Remember that with property, if you sell it to release the equity, you will pay capital gains, so it is sometimes better to hold onto it indefinitely.

Another option could be to start a business with the intention that over the next two and a half decades you will have built up something of value that could be sold. The proceeds of the business sale could then be invested in an annuity to provide you with the requisite income.

The safe option, in many eyes would be to find an employer who would provide you with a nice comfy “company final salary” pension scheme, and hope that by the time you get to retirement age, your salary is fairly high, thus affording you a decent retirement income.

There may even be a few other options, but I’m not going to go into them at this stage. Let’s move onto stage 4 which is the analyses of the various different options that can be taken to achieve your stated goal.

You may look at the option of starting a business with a view to selling it at retirement age and decide that’s not for you. That’s fine, at least you’ve explored the possibility. Similarly, if you’ve no interest in becoming a landlord, you may well discount that option too. And lastly if you don’t fancy being responsible for your own pension planning, it may be wise to discount that option and look to go and get a job with an employer that pays a nice final salary pension, and hope that the scheme will still be going when you come to retire.

Whatever you do with your retirement planning, you can be sure of one thing - you need to do some, and it won’t necessarily be the right type, but unfortunately, you won’t know until it’s too late. The most precious asset we all have is time, and no amount of money can buy any more, so it’s best to put some serious thought into what you will do about retirement when you are young, rather than just hoping that it will magically just work out all right in the end!

I read a lot of information about different sorts of investments, ranging from savings accounts to ISAs, to pension plans, to stocks and shares and property – but which type of investment is the best?

Well that depends on you, your age, your risk profile, your goals and most importantly, your understanding of investments.

Let’s take for example a young couple starting out in life, they have 40+ years ahead of them before retirement, their goal is to pay off their mortgage, have a similar income to what they have now in retirement and they don’t want to take any risks. They also don’t know anything about investing, and simply want to hand over their money to professionals and let them take care of it.

In this example, it would be wrong to suggest they look at anything other than ISA’s, pension plans and savings accounts. These can all be handled by an independent financial advisor and are all relatively risk free. Clearly as they get nearer retirement age, they should look to move their money out of ISA and pension funds that invest in the stock market and look to put the money into cash funds, but a good IFA will advise them to do this.

What can they expect in terms of a return? They can probably expect to do between 5% - 10% return averaged over the life of their investments, which with the effect of compounding should see them able to achieve their dreams.

What about an older couple who don’t just want to pay off the mortgage and retire at sixty five? What about a couple that want to retire young, say forty five? Following the same advice as the previous couple would not necessarily work, unless they were willing to invest a much larger proportion of their income – which if we assume that both couples have the same income, is not an option.

For a couple like this, they need a better strategy, a strategy that can deliver higher returns, consistently. So how can they achieve this? There are many ways they can achieve this, however the best thing for them to do would be to invest some of their own time in learning more about investing. Most independent financial advisors will not be able to help this couple, because most IFA’s will not achieve this goal for themselves, so how are they going to achieve it for a client? They won’t, simple as that.

For this couple, they will need to learn about investments that are more complicated than simply paying a direct debit each month. They will need to learn how to spot good investments themselves, which in itself will require learning what is good and what is not good.

In short, the best investment is to invest in yourself, increase your understanding of different investment types and make your own decisions. Don’t be afraid to take advice from people that have achieved your dream and expect plenty of people to try and dissuade you from doing anything other than the norm, including your financial advisor!

In fact, if your financial advisor doesn’t like the ideas you have, then get a new advisor that understands what you want to achieve and understands the methods you want to use to achieve your goals and is happy to help you achieve your goals.

I was just having a chat with a friend of mine who has a 2nd property which they rent out. They have no mortgage on this property, and at some point would like to access the capital in the propety, but don’t wish to pay the capital gains tax.

I suggested that there are two ways to do so, one would be to mortgage a portion of the property, the other would be to sell a portion of the property.

There are advantages and disadvantages to both, however, if you have sold rather than mortgaged a portion of the property, you will have realised a capital gain.

However, if you only sell a portion of the property that is less than the capital gains tax yearly allowance (currently £9,600 for an individual) there will be no capital gains tax to be paid, and because you have sold that portion rather than mortgaged it, there is no interest to pay. If you repeat this every year until you have sold the proportion of the property that was indeed a capital gain, then you will have realised capital gains without paying any capital gains tax.

You’re probably wondering how you could achieve this. By changing the ownership of the property into tennants in common rather than joint tennants, you will be able to split the ownership of the property up into fractions.

The inspiration for this idea came from the World 16 who do fractional property ownership schemes for investors.

I noticed that we recently had a post from a chap at World 16, who offer fractional property ownership clubs. I had a look at their website and contacted them to find out more.

It’s an interesting concept. They get together a group of investors who want to invest in property, but either don’t have enough money to put down a deposit or simply want to limit their exposure by only investing a small amount.

How they achieve this is by setting up a company that buys and holds the property, with each investor owning an equal share in the company and World 16 acting as the company secretary and management of the company.

Typically they get sixteen investors together, take £3,000 from each investor, subtract their management fees, and then invest the remainder into a good investment property, with the company taking on a mortgage to pay for the rest of the purchase.

I think it’s a great idea. It opens up property investment to a much wider market, as the entry price is the same as a cash ISA.

The real benefit they have however, is that unlike a cash ISA, they have the power of leverage, and a typical £3,000 investment could double within a few short years, unlike a cash ISA which would just about keep pace with inflation.

I don’t know if there are any more companies out there that do this, I’m betting that it’s going to become more popular, since mortgages are harder to get hold of, unless you can find a 25% deposit. I suspect it will become very popular for the “armchair” investors, who simply want to write a cheque and see a return in two, five or even seven years.

With the BBC reporting that thousands are facing negative equity, the number of house sold per estate agency dropping to just 17.4 in the three months to May the housing market is not looking good.

The BBC spoke to a representative of the Department of Communities and Local Government who pointed out that:

The long-term demand for housing remains high and the fundamentals of the economy are sound with low unemployment and historically low interest rates.

That I think is a key point, yes the market is in a mess at the moment, but it’s largely being caused by the difficulty in arranging mortgages, not because the demand has disappeared.

On the other hand if the economy doesn’t improve soon demand may start dropping, especially if we do enter a recession. While I hope we don’t, I do believe we are in for an economic slowdown which could be bumpy for some.

So would I buy a house now?

Yes, I would. While I believe the market will continue to fall for at least another six months I don’t think I’m smart enough to predict the bottom of the market. So I won’t even try, instead I’ll judge a purchase on it’s merits at the time.

If it’s a home for me and my family I’ll consider these questions:

• Can I afford to buy the house (making sure I’ve factored in all the costs)?
• Will I still be able to afford it if interest rates went up by 50%?
• Is the interest on the mortgage less that or roughly the same as what it would cost me to rent an equivalent property (I ignore the costs of the repayments in the mortgage/endowments/ISAs because they are not a direct cost of the mortgage)?
• If property prices fall would I be happy staying living in the house, or can I rent the house out and will the rent cover the interest payments on the mortgage?

If the answer to all these questions is yes, then I’d buy, no matter what the market is doing. If I’m considering the property as buy-to-let then I’d consider these questions:

• Is there a demand for such rental properties?
• Is there anything that might impact upon this demand in the near future (i.e. a glut of new builds)?
• What is likely the rent?
• After subtracting the cost of the interest payments on the mortgage and other running costs (insurance, maintenance and agents fees) does the property generate a positive cash flow (profit)?

If the answer to all of these is yes, then I’d consider buying the property as an buy-to-let. Unlike many property “investors” (arguably they are speculators) I believe in buying for cash flow not capital growth (which I view as a nice bonus if it happens). After all cash flow is passive income and passive income is vital to becoming financially free.

John’s article House Prices Really Are Falling got me thinking, and I posted a comment about the effect this would have on re-mortgaging, particularly with buy-to-let investors in mind. In the search for financial freedom, buy-to-let investments are well known as an instrument for creating passive income, and/or increasing the value of capital (by utilising the appreciation of the value of property). With this in mind this article highlights one of the (less obvious?) risk in the buy-to-let investment market. I will start with a short summary of how how mortgaging and re-mortgaging is used as an instrument in this kind of investment. I will then go on to give some sample figures illustrating how things can go wrong and what the damage might be.

Typically, mortgages can be obtained with a reduced rate for the first two years, and this is something investors rely on in as part of their business model. Also, with the reduced rate comes with a heavy financial penalty for redeeming the mortgage early. After the two years has elapsed, the interest rate goes up significantly. Therefore it is normal - and normally necessary - to re-mortgage every two years. Further, it is prohibitive - because of the heavy financial penalty - to re-mortgage before the two years is up.

Therefore, the expiry of the two year fixed rate is a point of risk in the business model of the typical buy-to-let investor. The point is this: because BTL mortgages are almost always interest only, the investor needs the new mortgage to pay off the capital on the old one. Also, how much you can borrow is directly linked to the value of the property. That is to say, when you re-mortgage, the amount you can borrow is a percentage of the new (fallen) value of the property.

What I’m going to do now is present an illustration that assumes the following:

• The value of the property when originally purchased was £200,000
• After two years the property value has fallen (by 8%) to £184,000.
• When re-mortgaging, the investor can borrow a maximum of £156,400 (that is, eighty-five percent of the fallen property value)

I have fixed the amount that can be borrowed when re-mortgaging, in order to show how the shortfall varies depending on what percentage of the original purchase price was actually borrowed. Also, I am assuming that eighty-five percent of the property value can be borrowed when re-mortgaging, and I have ignored arrangement fees.

• Amount borrowed for purchase (90%): £180,000 => £23,600 shortfall
• Amount borrowed for purchase (85%): £170,000 => £13,600 shortfall
• Amount borrowed for purchase (80%): £160,000 => £3,600 shortfall
• Amount borrowed for purchase (75%): £150,000 => £6,400 excess

Therefore the prudent investor who only borrowed seventy-five percent of the property price when the market was buoyant can withstand the eight percent drop in the property value. This investor will be left in the clear by £6,400! Note in passing, that this investor could actually withstand a fall of just under twelve percent in the property value and still break even.

Sadly not all BTL investors have had the prudence to allow for a fall in prices. I suspect that, sadly, there were many investors who bought into the by-to-let market without even realising they were exposed to the risk I have illustrated in this article.

If you read any of the property investment forums or the ‘house price crash’ forums that have sprung up in recent years you’ll be familiar with the idea of Sell To Rent (STR).  The basic idea is that at the end of a rapid rise or (more likely) at the beginning of a fall in house prices you sell your home and rent a property.

The theory being that you can then invest the equity from your home in a different asset class until house prices pick up again. The argument being that when house prices drop, stock markets (and other asset classes) tend to rise, so you’ll receive a better return by investing in them.

Which is all reasonable enough, but I still don’t believe it’s a good idea for everyone. For a start your home (especially if you have a family) is more than just an financial asset to be maximised, it’s a place full of memories, it’s a haven from the stresses of day to day life and your family may well have ties to the area: the school the kids go to, local friends and family and your jobs. Is the emotional upset worth the possible financial gain?

It might actually be more expensive to rent an equivalent home in the area and the increase in your cost of living may well consume any returns you receive from the alternative investments. Alternatively you may have to rent a smaller home and compromise your families standard of living.

Most proponents of Sell To Rent also neglect to consider the tax implications, whist there is no capital gains tax on your primary residence you will pay capital gains tax on any gains made on the stock market as well as income tax on dividends received. All of which erodes any gains made. In contrast if you keep your home you can rent a room out and under the Rent A Room scheme up to £4,250 a year tax-free.

Perhaps most important of all - there is no guarantee that the assets that you invest in will out perform the housing market, in fact they could do worse. Add to that the costs of selling a house and you might even end up considerably worse off.

Conversely of course if you do time both the housing market and the market for your alternative asset class right you could beat both the markets and do well out if it, the trouble is that in reality, few people - even the professional traders - beat the market.

Sell To Rent can work for some, but make sure you go into it for the right reasons with a good understanding of the choice you are making.