Is it time to stop worrying and start loving debt?
Back in the pre-GFC past, it was reasonable for Australians to pay off debt and put any spare money in a term deposit offering an underwhelming but reasonable return.
ANZ Financial Adviser, Michelle Li, spends a lot of time informing her clients that the pre-GFC world no longer exists.
“People believe they can’t lose money if they put it in a bank,” Li says. “But, in real terms, if you’re earning 0.5% interest on your savings and the inflation rate is 1.5%, you’re going backwards. If the inflation rate jumps to, say, 5%, you’re going backwards dramatically.”
A similar dynamic plays out with mortgages. “There’s a sense of security in knowing your home is paid off,” Li says. “I understand why homeowners, especially low-income and middle-income earners, want to reduce debt. But it’s a suboptimal financial strategy to put money into a mortgage you’re paying 2.5% interest on if you could direct that money into investments offering potential returns of 5-10%.”
Of course, it’s no simple matter getting a 5-10% return on your investments. But the long-term average returns on shares and super are in that range, so it may well make sense to put money that would otherwise go on your mortgage into an ETF [Exchange Traded Fund] or make voluntary super contributions.
Set yourself up for life
It’s helpful to be financially savvy at all stages of life. But it’s especially important in your middle years when you’re old enough to have accumulated some capital (and are in a good position to borrow more) but young enough to bounce back if the economy hits some turbulence.
“Many of my clients are individuals in the 40-55 age range who’ve done well for themselves,” Li says. “They are usually looking to make some sacrifices and take some risks to bolster the family finances and achieve their life goals. These goals can include being able to stop working early, making sure their children will be well provided for, and accumulating the funds for a fun-filled retirement.”
How debt optimisation works
Many people are familiar with the distinction between ‘bad’, i.e. ‘inefficient’, debt (such as purchasing clothes using a credit card) and good, i.e. ‘efficient’, debt (like taking out a mortgage to purchase a property that will appreciate).
Far fewer people are familiar with ‘debt optimisation’. There are a variety of ways to optimise debt – these are generally focused on improving your financial wellbeing by being strategic about minimising ‘inefficient’ debt and, where appropriate, taking on ‘efficient’ debt in the short term to build wealth in the long term.
In a low-interest-rate environment, a debt optimiser might be inclined to invest their annual bonus in shares, property or precious metals, rather than putting it on their mortgage or parking it in a savings account. A debt optimiser may even choose to take out a margin loan or another mortgage to buy assets with “cheap money”.
“I’ve just started working with a couple in their mid-40s who co-own a business with a healthy cash flow,” Li says. “Their approach to debt has been suboptimal. Most of their after-tax income is currently being put on their mortgage or going into their savings account. The long-term returns on Australian shares and property have historically been around 8-9%disclaimer and those returns are likely to be even higher in the short term, given economic growth rates are surging.” (At the time of writing, industry experts are expecting national house prices to rise by around 15-18% in 2021 and ASX 200 shares to provide a return of up to 15.4% in 2021.)
“So, I’ve suggested my clients consider investing their money rather than using it to pay down family debt. I’ve also advised that they could benefit from ‘debt recycling’, which is one way to leverage debt. My clients could use the equity in their family home – a non-tax-deductible asset – to invest in, for example, an investment property. Then they could use the rental income from that investment property to pay the mortgage on their family home.”
On paper, debt recycling can appear convoluted and even pointless. But it can potentially boost your financial wellbeing, especially if you are a high-income earner who would otherwise be handing 45 cents in the dollar to the ATO.
“You don’t get any tax deductions for paying off your mortgage quickly or accumulating money in a savings account,” Li says. “But it’s possible to reduce your tax bill by negatively gearing your investment property or share portfolio. All going well, you could benefit twice. You could get a tax break in the short term and, in the long term, you could enjoy a significant capital gain when you sell the property or shares.”
If you want to take a lower-risk approach, there’s always the option of upping your super contributions. Li says self-employed high-income earners should put the maximum amount – $25,000 (or $27,500 from 1 July 2021) – into super every year.
“Money in super is taxed relatively lightly,” she says. “Returns will vary depending on what fund you’re in and whether you’ve chosen the high-growth, balanced or conservative option. But, historically, Australian super funds have delivered solid long-term returns of around 5-7% per annum.”disclaimer
Risk mitigation strategies
A well-crafted debt-optimisation strategy combined with favourable economic circumstances could allow those in the prime of their lives to build substantial wealth rapidly. But, as the events of 2008 and 2020 demonstrated, it’s wise to be prepared for economic downturns as well as booms.
“You don’t want to be pursuing a higher risk, higher return investment strategy when you’re approaching retirement,” Li notes. “But if you’re going to be earning a healthy income for another decade or two, you have plenty of time to ride out troughs in the economic cycle.”
Nonetheless, Li argues even relatively youthful investors need to mitigate risk by ensuring they are appropriately diversified and insured.
“If you’d taken out a $1 million margin loan in late 2019 and invested it all into travel industry shares, 2020 would have been harrowing,” she says. “However, if you’d split the loan money between travel industry shares and household-goods retailer shares, the losses and gains would have more or less evened out.”
Li warns would-be investment property buyers to be aware of the downsides of that asset class. “Australians often only think about the pros of owning an investment property,” Li says. “But property is an illiquid investment, which means it’s difficult to convert into cash. Plus, there’s always the possibility a tenant will be unable or unwilling to pay the rent. I’m not arguing against buying investment properties, but people should be aware they don’t have to do that to get exposure to the property market. They can get that exposure by investing in REITs [Real Estate Investment Funds] and property ETFs [Exchange Traded Funds]. These are liquid investments and provide much more diversification than a single investment property, or even a portfolio of investment properties, can.”
Li’s final piece of advice is to be adequately insured when investing with borrowed money.
“High-income earners often assume they’ll always have plenty of money and never have to worry about making their loan repayments,” she says. “But if you don’t have the right cover, you could be forced into a fire sale of your assets if misfortune strikes.”