Say What Wednesdays
Debt Recycling & Leverage
Welcome to Finance & Fury, the ‘Say What Wednesdays’ editions!
Today’s question comes from Dale: “My question refers to a point you and Jayden made a few times about recycling debt or using good, specifically using equity to purchase shares. I understand that you can claim the interest paid on the equity as a tax deduction. So, does that mean you have a second loan to pay down? And also, how does it look at the backend when you want to liquidate your shares?
Today we will run through each one of these covering off on Leverage.
Leverage is when you borrow to invest money, and why do this? Well, is $100,000 more than $50,000? Agree or not? It is! And that is what leverage does. Borrowing fund to invest into something to increase the value of the investment.
And it works off getting percent returns, where the greater the value of something, the greater your real return in dollar figures off the exact same percent when compared to a smaller investment.
We are all really locked into the same return the ASX can give. If you put money into the ASX300, everyone invested in the ASX300 gets the same return. However, those with more money in it will get more of a dollar value of a return.
That’s the whole “Rich getting Richer” saying, where the same percent increase off a greater value will lead to a greater return.
Now on to good debt. As Dale said, if you can claim the interest against the debt, it is generally considered good. And to make it eligible to do that it needs to be invested in an income providing asset.
More importantly though, good debt is debt that is being used towards something that will actually go up in value. If it is on a personal loan or something that will actually go down in value, that is what it is bad debt with credit cards or personal loans. Plus, no deductions.
But for good debt, if you take out $100,000 to invest in shares, the shares should increase in value while the debt shouldn’t. It shouldn’t go up with inflation, so using leverage can help to increase your overall wealth when your starting values are relatively smaller than what you would like.
As a warning, when borrowing funds to invest both your positive and negative returns are magnified. This is general information only!
But how borrowing to invest works in this case is from what is called home equity, where you borrow money out of your home to buy shares or managed funds.
Equity it just money you have in the value of your home. If you have a $1m home, you can borrow up to 80% of that value. So, if you don’t have any debt against your property and it’s worth $1m, you technically have equity in that property of $800k which you can borrow to utilise to invest.
And even though it is your own personal residence, because you are borrowing funds to invest in something that produces and income, then that will actually become a tax-deductible expense with the interest payments. As opposed to if you took money out to buy a second holiday home.
And any investment that you invest in that produces an income, you can claim deductions against it. Either for the cost of the investment (management fee of the platform you are invested on) or the interest that you have to repay on the borrowed amount.
Now, the process of borrowing money against the home going back to Dale’s question.
You do need generally to get a separate loan if you have bad debt attached to your home. So, if you have a home, again $1m, and there is a $500k mortgage on it, that 500k mortgage is your bad debt. But then you can create a separate loan (or second loan) and borrow money on that.
The reason why you have to take out a separate loan is to keep track of the interest components of repayments. Because if you have one loan that is principal and interest that is bad debt, and you take out more money on top of that and invest those funds, it is going to be very hard on a month to month basis (especially if the rate is variable), to work out what component is interest of the repayments towards the investment and your mortgage.
Mainly, accountants require a second loan and the ATO requires a second loan to actually make sure the interest being claimed is 100% accurate. And with the separate loan, it does mean that you have to pay it down……if you choose.
But you have time! Like all loan you can take an additional 30-year loan on a separate facility on your home. But if you do want to pay it back, then yes, you over time will have to repay it.
And the deductible interest you claim that at tax time. The way that works is during the year you earn your income, then when you lodge your tax returns you’ll list on there income earned from investments and personally, and the interest you have paid on those investments to offset the income.
Why it’s great to have a separate loan as well, is that you can structure it differently to your bad debt. And one of the best waits to structure investment loans may be on Interest Only payments rather than Principal and Interest, because if you are on a Principal and Interest payments half or sometimes majority if it is a new loan it will be paying off principal which is not deductible.
And over time, maybe after 15 years, the majority of your repayments start to become principal with little interest. So, you’ll be paying the same amount on the property, but how much you can claim as interest on that isn’t actually going up, its going down over time.
The other thing is flexibility, having an offset account on there against that loan allows you to have a separate offset account which is your cash fund for investment purposes.
And unlike margin loans, the home is the collateral for the investment. Therefore, the investments can be independent form the collateral. If you get a margin loan you need to get a loan on every share that you get, in this case you are just borrowing money against the home which is collateral itself, then investing that in really any investment.
So, the loan isn’t attached to the investments itself you are making. And that works a lot better as it is safer than a margin loan where you can hold the investments if they go down in value, indefinitely. With a margin loan, if the investment goes down in value but your loan doesn’t decrease the bank will step in. Remember that you loan stays the same as when the investments go up, but you loan stays the same also when your investments go down, even below what the loan is.
So in a case where you have a margin loan and the value of the investment goes down, when the value of the investments is below the loan the banks going to tell you need to buy more of the investment, sell investment to repay loan or repay loan using your cash.
That is actually a greater risk, because you are forced into a situation where it might not be the right investment to buy, as it is going down! Or you have to sell an investment and crystallise the loss.
The second benefit with home equity compared to margin loan is the lower rate. Again, a home is a much less risky collateral for the banks to have, than a share which is much more volatile.
So that is the initial proceeds, you borrow money against the home with a separate loan with an offset account generally attached to that separate loan, then you invest the funds.
You take money out of that loan and invest the funds. This can be in any asset as long as it produces an income. It should be in certain types of assets to not introduce additional risks, you wouldn’t just borrow $100k and put that into one bank or mining share.
The ongoing strategy from there, you can either keep borrowing money as the value of the property increases, you can keep the loan the say, or you can start paying it down.
And that is where over time you can choose to do really whatever you want with that loan! And that takes us back to Dale’s question again. If you want to repay the loan at some point, you can do it early, or can wait until the 30 years is up. Either way it will take a bit of planning to do, as if you want to repay the loan without selling the investments, you have to plan ahead and utilise the investment income, to use this surplus income plus your cashflow to use this to repay your debt down quicker.
But a bit of a better strategy, if you are looking at repaying debt, pay down your bad debt first. So, use your investment income to pay down your personal mortgage, as that is not deductible. And it isn’t borrowed funds against an investment asset! Therefore, you can over time try to pay down bad debt, and then figure out what to do with the good debt. With the good debt, that should be the last one to pay down if you have bad debt, but if you plan properly over time you can work out over time how much in repayments it will take to pay this down by the time you need to.
And the other option is to sell the investments. So, as far as liquidating the shares go, you can do that at any point as well. You don’t have to sell all of the investments, you can just select one investments in the portfolio that does have a large capital value increase to pay out the loan.
Because when you sell that investment you will pay capital gains tax on this. And that won’t actually be reduced by the loan in any way. As it is only the ongoing interest payments that you can claim a deduction against. It’s not like you’ve invested funds that are borrowed and what’s invested goes up, that you somehow get a reduced tax on the capital gains tax. It works the exact same as if you bought the investment with your personal cash rather than borrow funds.
So, those are the options, but it is probably better to plan over time to pay the loan down. But because it is an equity loan that is against a home, and the home is the collateral for the investments (and not themselves). That is why the investments are independent and you can choose that to do what you want with them over time.
So, they are unrelated unlike with a margin loan it is attached to the individual share, so if you want to repay that again, you got to pay the bank back their money or in that case sell the investment. But here, there is more flexibility. So, you can choose to do whatever you want when it comes to when to repay the loan and how to repay it. You can also choose over time to increase the loan as the property value increases, keep the loan the same or choose to pay it back.
The last thing is if you choose to sell the property that the loan is attached to. If you have equity borrowed against the property and you sell it, the investments don’t have to be sold, they can stay in place. It just means that when you get the proceeds (or equity) out of the remaining money in the property once it is sold, you will just have less to put towards the next property to buy. If you have a $1m property with no debt, you get $1m of proceeds. If you have a $1m property with $800,000 of debt, then you will get $200,000.
I hope that covers everything. The questions were just relating to understanding that claiming the interest as a tax deduction, but does that mean you have to pay down a second loan? So, you do, you borrow a second loan, you don’t have to pay it down on Principal and Interest, you can pay it on Interest Only and transfer savings into an offset account, which technically means you aren’t paying the loan back but still reducing your interest. But at some point, the bank will want their money back. When it comes to winding the investments up at the back end, do you liquidate your share? Well you can but it is probably better not to.
Thank you for the question Dale, I’ll do a more detailed episode on this in episode 6, covering off how the rich really get rich!
But if anyone has equations, go to financeandfury.com.au/contact and hit us up with something like Dale’s question, or Adam’s last week.
I hope you enjoyed it!