DEBT MANAGEMENT

So what are the better things to do with your money?

  1. Any private thing instead of borrowing for it

  2. Superannuation contributions

  3. Buy more investment assets

Interest only loans

Positive and negative gearing.

Chapter 4 - Investment debt and how to manage it

So far, we have looked at private debts such as home loans, personal loans and credit cards. Now, let’s take a look at investment debt.

Investment debt is debt taken out to buy investment assets. These are things like investment properties and/or shares. Borrowing to buy investment assets is known as gearing.

Investments purchased using borrowed money, at least in part, are sometimes referred to as ‘geared assets.’

The key difference between investment debt and personal debt is the tax treatment of the interest. For personal debt, interest is not deductible. For investment debt, it usually is. This means that a person need only earn a lower amount of pre-tax income in order to pay interest on an investment debt.

We need to make an important distinction here. When you have an investment debt, you have to pay two amounts to the lender. One payment is to return the amount they lent you. This is known as the principal, and repaying this amount is called a principal-repayment. The other payment is the interest on the amount that you have borrowed.

 

When we talk about deductibility, we are only referring to interest payments. Principal repayments are never deductible.

 

So, the interest on investment debt is typically deductible. For this reason, the basic concept regarding investment debt is this: you should only repay investment debt if there is nothing better to do with your money.

 

Think about this for a minute. To better understand what we are saying, remember that whenever you have debt, you have effectively borrowed money whenever you use money to do something other than repay that debt. This is because you could have used the money to pay off debt. To use a simple example:

 

Suppose I owe $1,000 on a personal loan. I then receive $1,000 as a gift. I have two choices. I can spend the money on the latest flatscreen TV, or I can pay off the debt. If I pay off the debt, I will not have any debt left. If I buy the TV, I will still owe $1,000. So, if I buy the TV I owe $1,000 more than I would have otherwise. I have effectively borrowed $1,000 to buy the TV.

 

Now extend this out to your investment debt. The interest on this debt is deductible. If I have some money, I can either repay this debt or I can use it to buy something else. If I use it to buy something else, then I have effectively borrowed to buy that item. In this case, though, I have effectively made a tax-deductible borrowing to buy that other item. This is the case even if the item is a private one, such as a TV.

 

This works because the original debt was used for an investment purpose. The interest on it remains deductible, regardless of whether I could have repaid it if I had wanted to.

 

For that reason, it would not make any sense to repay investment debt and then use borrowed money to purchase private assets.

So, what are some of the better things to do with your money?

 

So, you should only repay investment debt if there is nothing better to do with your money. Usually, there are such things, so let’s look at a few of them.

 

1. ANY PRIVATE THING INSTEAD BORROWING FOR IT

 

There is no point in repaying deductible debt if you then have to borrow money to buy something that is not deductible. For example, let’s say you have $30,000 and you need a new car. The car is for private purposes and so debt taken out to buy it would not create deductible interest. It makes no sense to use your $30,000 cash to repay deductible debt and then borrow to buy the car. You have effectively swapped cheap debt for expensive debt.

 

The same goes for things like improvements to your home – or even an upgrade of your home. These are private expenses, so pay them before you repay deductible debt.

 

The private ‘thing’ might also be to help someone else, such as an adult child. Instead of paying down your deductible debt, you might create a savings account which is offset against your adult son or daughter’s private home loan. The family is much better off to avoid non-deductible interest in the kid’s hands rather than avoid deductible debt in mum or dad’s hands.

2. SUPERANNUATION CONTRIBUTIONS

Most people cannot borrow to pay deductible super contributions. However, as we have seen, if I choose to make extra super contributions instead of repaying debt then I have effectively borrowed to make the contributions. And if the debt that I have not repaid is deductible, then I have made a deductible borrowing to pay for the super contributions.

 

Think about an example. You are fifty years old and you have just made the final repayment on your home loan. You also have an investment property loan of $240,000. You have been paying $1,000 a month off your home loan each month. You now have an extra $1,000 a month available. One option is to start repaying this amount off your investment loan. But a better option is to increase your super contributions.

Let’s say your marginal tax rate is 30%. This means that the $1,000 you have been repaying on your home loan has required you to earn $1,400 or so before tax. This is $16,800 a year. Now that the home loan is repaid, you could consider talking to your boss about sacrificing an extra $16,800 pre-tax into super. This money would only be taxed at 15%, meaning that you would be left with $14,280 in the super fund. Had you instead tried to repay $1,000 of your investment loan, you would only have reduced the debt by $12,000. So, this strategy leaves you with $12,000 more debt than you would have otherwise – but your assets have increased by $14,280. You have actually created an extra $2,280 of wealth.

 

This strategy will ultimately let you repay the investment loan more easily. Remember, the principal amount of any loan needs to be paid using after-tax dollars. This is the case for both private and investment debt. This means that by running your wages or salary through the lower-taxed super fund, you have more remaining to repay the principal once you reach preservation age. (Preservation age is the age at which you can withdraw money from the super fund and use it to retire debt).

 

But, even then, you would only withdraw the money and repay the debt if you still had nothing better to do. Read on to the next section where we will explain in greater detail.

3. BUY MORE INVESTMENT ASSETS

 

Instead of repaying deductible debt, you could also use the money to buy more investment assets. This is particularly the case if you are able to buy smaller parcels of asset such as shares or units in a managed fund.

 

Buying more assets has the same short-term effect on your net asset position as repaying debt would have. Net assets are your total assets minus your total debts, and this is really the best way to calculate your wealth. Consider the following example:

You have an investment debt worth $240,000 and total assets worth $1,000,000. Your net assets are $760,000.

You inherit $40,000. If you use the $40,000 to repay the debt, then the debt drops to $200,000. The assets are still worth $1,000,000, so your net assets are now $800,000.

 

If you use the $40,000 to buy more investment assets, then your debt stays at $240,000, but your assets increase to $1,040,000. Your net assets are also $800,000.

 

The two cases seem to be the same, with net assets of $800,000. But it is usually better to own more assets than fewer. Over time, if the assets rise in value, then you will be applying that rise to a larger amount of assets. This is, after all, why you borrow to invest in the first place: because you expect that the increase in the value of your assets will exceed the interest you incur on your debt. So, if asset values rise, then the higher the assets, the more wealth is generated.

Interest only loans

 

One way to ensure that you only have to meet the interest expense on an investment loan, and you do not have to repay principal, is to use an interest-only loan. As the name suggests, an interest-only loan is one in which borrower only meets the interest requirements of the loan. He or she does not have to repay principal amounts. To give a simple example: if you borrow $100,000 at 6% per year, and you only have to make one repayment a year (this is an illustrative example), then the amount paid to the lender will be $6,000. At the end of the year, you still owe them $100,000.

 

Interest-only loans can work really well when borrowing to purchase investment assets. By making these ‘investment loans’ interest-only, you avoid having to use cash flow to make loan repayments on debt that is giving rise to tax-deductible interest. Accordingly, ignoring changes in interest rates, the amount of tax-deductible interest does not reduce over time.

 

By not repaying the principal amount of the investment debt, you ‘free-up’ cash flow to be used for some other purpose. This may include repaying private loans, making super contributions, buying private assets, buying more investment assets, etc.

 

Interest-only loans are used where you expect the capital value of the purchased asset to increase over time. To give a very simple example: suppose you borrow $100,000 as an interest-only loan and use it to buy units in an index fund. The loan term is five years. After five years, the index fund investment has increased in value to $130,000. You sell $100,000 worth of units in the managed fund, repay the debt and you are left with a debt-free asset worth $30,000.

 

Of course, there is a danger that the asset will not rise in value – but this is a risk of all investment borrowing and is not specific to interest-only loans. And, where interest-only loans reduce the amount of after-tax interest being paid on all of the borrower’s loans, they can actually serve to reduce the overall risk to the borrower.

 

ASIC tells us that 2 out of every 3 investment loans is interest-only, while 25% of owner-occupied loans are interest-only. You can read more about interest-only loans on the ASIC website here.

Positive and negative gearing

 

You have probably heard of the terms positive and negative gearing.

 

Negative gearing occurs where the income from a geared asset is less than the interest and other holding costs, creating a loss. Investors can usually offset this loss against other income for tax purposes. This creates a tax benefit, in the form of less tax being paid than otherwise, and this tax benefit in a sense adds to the investment return on the asset.

 

Negative gearing does not make economic sense, however, unless the client expects to earn a capital gain greater than the loss, so that overall the client is better off by making the investment. This capital gain is not taxed unless the asset is sold, and even then usually only half the gain is taxed, provided the asset was owned for more than 12 months.

 

The most common area in which you see negative gearing is with property investment. The prevailing interest rate for investment property loans is currently around 5 to 5.5%. The prevailing rental yield is around 3 to 3.5%. This means that rent won’t cover interest if the investor borrows all or most of the purchase price of the property.

 

Have a look at this short video from the team at the Eureka Report. It explains negative gearing quite well:

 

Positive gearing is where the income from a debt-financed asset exceeds the interest cost. For reasons outlined in the previous paragraph, it is rarely seen in property investment unless the investor has borrowed well below the full purchase price of the investment. Positive gearing can be more common in share investing.

For example, in a December 2012 ASX Investor Update newsletter Paul Zwi from Clime Investment Management observed that National Australia Bank shares offered a high dividend rate of 7.5% or 10.7% grossed up for franking credits. Clients who borrowed to buy NAB shares would have experienced positive gearing: the dividend return was greater than the interest cost.

Positive gearing can work especially well with a debt recycling strategy as outlined above. This is because the income return, such as the dividends, can be used to retire non-deductible debt, while the deductible borrowing is used to pay for anything for which claiming a tax deduction on interest is legitimate.

 

You will occasionally hear about properties that are marketed as cash flow positive (positive gearing). Be careful. These properties typically either have an artificially-boosted rent (such as guaranteed rent for some limited time) or the purchase price is abnormally low. Both situations should give you cause for concern.

Whether you are positively or negatively geared, your tax liability is worked out the same way. You add the income return (rent or dividends) to your taxable income, and you deduct the interest expense. In negative gearing, you are therefore deducting more than you add, because the interest is more than the rent or dividends. This lowers your taxable income and you have to pay less tax. This reduction in your tax liability can ‘lessen the blow’ of negative gearing. But it only lessens it: you still make a very real loss in the short term and you must compensate for this with a capital gain or you will be worse off. So, the tax benefit of negative gearing is really only the icing on the cake: it is not the whole cake, and you should never make an investment solely or even predominantly because it is negatively geared.

 

In 2016, we published a comprehensive guide to negative gearing. You can read it on our website. We hope you like it.

3. Consumer debt and how to manage it
5. Special purpose debt:
Reverse mortgages

 ©2016 WHOLE WEALTH

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