Money that makes more money is the ultimate dream of any investor, so how exactly does this work?
Realestate.com.au finance experts Ben Kingsley and Bryce Holdaway from the Property Couch are on hand to help you learn more about property investing.
But before we get to the exciting world of compound interest, time for those boring yet important words of warning about your personal circumstances.
This information is of a general nature and does not constitute professional advice. You should always seek professional advice in relation to your particular circumstances.
So what is compound interest?
Compound interest is all about delaying financial gratification in the short term so that you can earn more in the long term, says Holdaway.
“Think of it this way, if you’ve got $10 and it earns 10%, at the end of the year you have $11,” he says.
But over time, the interest that you earn grows as you are earning 10% on the increased funds.
“But next year, when you earn 10% on the $11, you actually get more than that initial dollar increase over time,” he says.
So the interest you earn is still 10%, but as the total amount of money that the interest is earned on has increased, so too does the amount you earn.
This is what’s called compound interest.
How does it relate to money earning money?
Compound interest is magic stuff for investors as it can help earn more money over time, says Kingsley.
“It’s actually all about over time and as it (the investment) grows in value, it gets bigger and bigger and bigger. So you’re earning money on money,” he says.
What’s all this got to do with property investing?
Compound interest can often mean a property investor’s money is earning more money, he says.
“That compound interest is a powerful thing because if we have a little bit left over and we put it into a property, over time it grows. And not only in isolation does that property grow (in value), but imagine if we tap into it so we can buy a second property and a third property. So that power of compound interest is just exponential,” he says.
Compound interest is great for investors in a rising a property market as the longer an investor can hold onto an asset or property, the more money they are likely to make. In this scenario leveraging the equity from one property and using it to buy another is a smart move.
But when prices fall, things can get tough for investors as rental income declines and some may struggle to service their debts.
Regulatory concerns over investor loans in Australia has resulted in major lenders significantly tightening their lending criteria for investor loans, also called interest-only loans.
Some like the Australian Prudential Regulatory Authority worry about an investor’s ability to service a loan, independently of the rental income they may earn on a property.
For more from The Property Couch, visit thepropertycouch.com.au or subscribe to The Property Couch podcast, available on iTunes or Android.
The Property Couch provides general opinion based on current market conditions. These opinions should not be treated as investment advice. Always obtain advice based on your individual circumstances.