Welcome to Finance and Fury. With interest rates on the rise, is borrowing to invest still worth it, also is it best to reduce debt or use it to build wealth?

  1. Borrowing to invest is a strategy known as Leveraging – Purchase assets with others money, but you pay a price to do so – which is the interest expenses charged for the borrowings
    1. how leverage works – essentially this is borrowing money to invest – Agree or not – $100k is more than $50k?
      1. Borrowing to invest allows you to increase the value of what is invested
      2. Technically your net wealth hasn’t increased initially – but over time this ideally can change at a greater rate, due to leverage
    2. This is due to the fact that returns come in percentages – the greater the level invested – greater nominal returns at same percentages – We are locked into same percentage returns for the average property held, or for ASX index – but what changes is the different values that are invested
      1. This is the foundation of the statement “the rich get richer” – everyone invested in the ASX gets the same returns, but if you have $1m invested compared to $10k, a 10% return is the difference of $100k to $1k
    3. The premise of using leverage is that as time goes on, your investment increases, debt doesn’t – but you will pay the interest costs – The good side to this is that growth and income returns are ‘leveraged’ by the level of borrowings – the bad side is that you have to repay an interest expense – even though this is deductible – any principal components aren’t

So with interest rates on the rise – is it better to pay off debt or use it to accumulate wealth – First we need to look at the economic problem –  

  1. That being finite resources with the potential for infinite wants
    1. Wants and Needs – We have a lot of them – depending on the individual this will vary – but we all have the capacity for unlimited wants, from private planes and islands
    2. But when it comes to funding these wants – financial resources are required – things cost money – Which is typically more limited than our imagination
    3. Balancing act – Use what you have to get where you want to be

Debts can be against many types of assets that we wish to purchase – borrowings allow us to meet more of our wants than if we couldn’t borrow – from cars, holiday, to homes, investment property and other forms of investments

  1. Take for instance a home – what is this? a lifestyle asset – is still technically an asset as it has a value – as long as someone else is willing to buy it off you – But I personally have never really seen a home as a financial asset – it technically losses you cashflow when it has a mortgage – and even when it doesn’t from a mortgage if this has been repaid – with rates, body corporate, ongoing maintenance costs for upkeep on the property
    1. In my view – anything that doesn’t make you a passive income or generate a form of tangible benefit but instead loses you cashflow can’t be used for financial independence – this is where a home can, if you grow food, have your own water and power
    2. But generally, property ownership is expensive – mortgage is normally the biggest expense – and as interest rates are now increasing again, this is especially the case
    3. PI loans eat a lot of cashflow – but the P component can be treated as forced savings that you can’t use

Is it worth this to do so? With your finite resources in the form of disposable income – do you invest, or pay off debt – Hard decision – Factors that should help to determine the answer to this question

  1. First – Stage of life you are at and the timeline until you need to be debt free
    1. This helps to determine your priority – Where interest rates are at always matter – but if you are 20 years from needing to be debt free versus 5 years – then depending on if you are on track to achieve these targets, additional cashflow would be needed towards paying debt off, as opposed to investing where they compounding returns over 5 years aren’t as beneficial compared to 20 years
  2. Second – There is always an opportunity cost when looking at the options of cashflow – the answer to this question, the answer will almost always be yes – i.e. “what is the next best option for using your savings?”
    1. You can Reduce debt – this will save you an interest cost each year –
    2. You can build wealth personally by either investing month to month, or borrowing to invest – Expanding your borrowings and debt levels
    3. You can save the money – in cash, or offset accounts – this can have the same net effect as repaying debt when it comes to interest saved
  3. If you decide that you have enough time to pay your debts off before retirement and you are comfortable meeting interest costs on debts as they increase – The only option left is to Build wealth – Investment options
    1. Buying a geared investment property, Monthly investments, Salary sacrifice – Super, using leverage though investing using borrowed funds against a PPR – equity release
    2. As interest rates increase – Leverage works better from allocating investments to higher levels of growth and defensive assets that purely generate a cash flow yield, such as FI.

higher interest rates don’t necessarily diminish the effectiveness of borrowing to invest – as long as capital growth and income are present – what is also important to look at is to decide on how much is affordable to borrow based around your ability to repay the loan and your timeframes –

  1. In many cases, as interest rates rise it may not be worth it to borrow the full amount that you are able to –
    1. Through releasing additional borrowings, or releasing additional equity on existing properties back up to 80% loan may just cost you additional cashflow – and work against your goals
  2. One question you can ask yourself is, will you beat your expected hurdle rate in the strategy that you are looking at?
    1. Hurdle rate – the minimum rate that you expect to earn when investing after tax
    2. When borrowing to invest, your hurdle rate will be the cost of borrowing the funds (interest payments) – plus any other associated costs – principal repayments can be excluded in many cases, due to be the equivalent of forced savings – but this is another burden on your cash flow on top of the interest expenses
  3. Say you have $100k of cash, which could be invested in a property, the share market/managed funds, or paid down on a loan and reborrowed to invest in shares or managed funds –
    1. The benefits of each strategy depend on the assumption – if property grows at the same rate as shares, then having a $500k property versus a $100k invested in shares results in a return of say $50k vs $10k – but what is it like if you then invest the amount you would pay in loan repayments, property costs, etc. into shares versus the capital growth off a property? The numbers start to become more even – A lot of this is assumptions based – but the higher the interest rates on the loan, the higher the outgoing cashflow requirements are if levered is deployed
  4. Example: Person with $520,000 mortgage, just bought first place so 30 years time – Prepayment $3462 p.m – they have $20k in cash that isnt needed
    1. Option 1: Pay $20,000 onto a loan, or invest the money – 30 years – Loan – rate of 7% long term rate and PI, versus lower rate
      1. 7%: 30 years would save you $123,301 in interest and 3 years or repayments – If you kept your repayments the same
      2. 5%: 30 years would save you $63,787 in interest and same 3 years – If you kept your repayments the same
    2. Option 2: Investment – Put $20,000 into portfolio, getting 8% p.a. for 30 years
      1. 30 years would be around $186k to $200k invested.
      2. But taxes on invested income – Return: 4% Income + 4% growth, income will be taxed.
        1. Either fund through cash flow, Or use investment income to pay for
      3. Even better? Pay down the loan and redraw the funds as separate investment loan.
        1. Convert debt to good debt. – Debt recycling that we have covered
        2. Have best of both situations – Have investment, and while paying interest it is deductible.
  • You would have the $200,000 in investments and pay the loan with $123,301 of deductible interest along the way. Depending on MTR: lowest marginal tax rate: $25,893 to $57,950 at the top.

Let’s look at an example: Investment Property – Initial purchase and building equity

  1. Utilise equity of $100k to purchase a property for $500k, so borrowed funds of $400k – LVR 80%
    1. At current interest rates for new investments, around 5% – $2,148 p.m. – at 2.5% was $1,581
    2. Principal repayments initially would be around $1,113 p.m. – so this is additional forced savings, so the question is if the interest expenses after tax, which could be considered dead money is worth it for the capital growth
  2. To take this further, say in three years – you see a 10% growth return = $50,000 gain to see the property worth $550k
    1. Growth return on the equity of 80% – $40,000 in available equity
  3. In addition – you will have repaid some of the loan – $380k in value by this stage as well with standard monthly PI repayments – so in total there would be $70k of equity available – but you have paid $58,600 in interest expenses
    1. Rent may have been around $400 per week – so in pre-tax and other costs terms, this is $3,800 positive – but once you account for BC, rate, insurances, etc, it is probably slightly negatively geared
    2. But in cashflow terms – you will be behind in principal repayments – of around $19k
    3. The higher the interest rates go, the worse a property investment can become – lower capital growth, higher costs, etc.

When borrowing to invest – minimising risks – avoid the areas where it goes wrong

  1. Wrong investments Shares or managed funds?
  2. No liquidity, or not reducing investment time risk – DCA
  3. Using highly volatile investments as collateral – with margin loans
  4. Disposable cash flows low – job security
  5. Panic selling or being forced to sell
  6. Buffer account – lower LVR or surplus cash

Summary – Remember this isn’t advice, just things to think about: Process to answer the question: With higher interest rates – Should I pay down debt or invest it?

  1. Ask yourself if it is debt or investment as the priority to reach your financial goals?
    1. Am I on track to retire with enough invested?
      1. Yes – Means you have enough to cover what you will need
      2. No – You may need to focus on investments more
        1. Timeframe
      3. Do you have bad debt? Yes, will it be paid off before retirement?
        1. Do you need to pay this off quicker?
        2. How much, and by when?
      4. If it is good debt, will the investment be able to pay for itself before retirement?
        1. Or, will the income be needed to provide a passive income? i.e. used to live
      5. Putting it all together: Rules of thumb – Not always the best! Not advice, but guidelines:
        1. Bad debt it always bad.
        2. Good debt declines in value the closer you are to retirement.

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