Expert Advice: Rich Harvey
Many of us have been brought up with the fear of taking on more debt. My parents were fairly frugal and the family budget was tight. Their main goal was to pay off the home mortgage as first priority. However if you wait 25 years to pay off your home loan before investing, you will have missed two and half property cycles to create a property portfolio. This article challenges “debt aversion” and looks at alternative ways for greater wealth creation.
Debt is often used as a dirty word and we typically shy away from taking on more debt than we feel we can manage. I’m sure we have all heard stories or know someone that got into too much debt. We only have to look at the sub-prime debt crisis and the fall out from the GFC to know that the wrong type of debt can result in dire consequences.
But there is another side to debt. While too much debt can get you into all sorts of trouble, good debt (in reasonable amounts) can help you achieve your goals at a much faster rate. The trick is to know when and how to use debt in an effective way.
Debt is a bit like a chainsaw. It’s a great tool to help you deal with big issues that might otherwise be impossible to achieve (eg, buying your first home, building an investment portfolio for retirement or starting a business). But if you use it the wrong way, it can cut you off at the knees! Being smart with your finances and using debt responsibly can take your life to the next level.
Here are seven reasons I believe that sustainable debt can be good for you.
- Make money using debt.
By leveraging your savings and equity, you can borrow more money to invest in a property as an appreciating asset. Very few people ever “saved” their way to retirement. Using bank finance to acquire multiple properties is a smart way to build your property portfolio. The amount you can borrow from a bank will be determined by your income and other assets. The amount you leverage will depend on your age and stage in life. If you are just starting out and have a high income, you may be able to borrow 90% of the loan amount, while someone approaching retirement would adopt a more conservative approach of a 50% loan to value ratio. The trick to leveraging with debt is to select property assets that are well positioned for strong capital growth and low risk of vacancy. After a few years of growth you may be in a position to refinance the loans so that you can draw down the increased equity to use as a deposit for your next property. I have done this many times over and it is one the key strategy to growing your property portfolio faster.
- Disciplined spending
Taking on more debt makes you seriously watch your spending habits. With more money at stake it’s important to have a good handle on where your money flows each month. Having a property debt also means you have a type of forced savings program. What would you spend your money on if you didn’t have to cover a home mortgage and other property debts? You would probably spend it on consumable and lifestyle items that depreciate rapidly. A property mortgage rapidly puts you on the path to having more control over your spending. One of the other key benefits of debt is that you build up a good credit rating with the banks so that when you need to apply for another mortgage, they can see you have a clean credit history.
- Debt gives you a long term focus – future proofing
Using debt to buy a property (or properties) is not a short term strategy. It gives you a long term focus toward retirement. By working out how much you want to retire on, you can easily work out exactly how much debt you need to take on to achieve your goals. For example, if you want to retire on a passive income of $100,000 pa, simple modelling shows you would need to have $2 million of net property assets at retirement age earning a rental yield of 5%. But to obtain $2m of net assets, you would need to acquire a total property portfolio of $4 million using leveraged debt over a period of time (say around 10 to 15 years) then sell around half of the portfolio to pay down the debt.
- Tax deductible
Obtaining debt to invest in property means the interest on the loan is tax deductible. This is one of the reasons why property debt is also called “good debt”. However, don’t just select a property investment solely for tax benefits (this is only the icing on the cake). You must consider the fundamentals of capital growth and yield.
- Allocates resources to highest end use
Using debt for investment purposes will make you consider where you can get the best return. The return you get on the investment should outweigh the interest you pay on the loan over time. Negative gearing, neutral gearing or positive cashflow strategies are all useful and legitimate strategies for property investors. However, be careful to select property investments that will appreciate at a much faster rate than your gearing ratio.
Adopting a negative gearing strategy will only work if the capital growth rate of the chosen suburb exceeds the negative cashflow required to support the property over time. For example, let’s say you have purchased a property for $500k which costs you around $7500 per annum in net costs (after accounting for rent, repairs, interest, strata fees etc). This property needs to grow by at least 1.5% pa to break even. By investing in well selected property assets you are building a nest egg for yourself.
- Cheap form of finance
With interest rates at all time historic lows, taking out investment property loans to grow your portfolio is a smart move. Taking on new debt can make more sense than liquidating other assets such as shares or bonds.
- Even out your cashflow
Having a line of credit or off-set account is a smart way to even out your cashflow as a property investor. Sometimes as investors we may get hit with a few big expenses all at once. The hot water systems breaks down, the land tax bill is due and there is a two week vacancy coming up. Having a buffer in your debt account makes it easier to ride out these pressured times.
The amount of debt we carry should be manageable relative to the value of the assets we hold and the servicing capacity we have for the debt. Remember - debt is like a chainsaw. Get it revved up when you want to start your property investment strategy, but handle it with care.
Managing Director, propertybuyer
This article was written by Rich Harvey, founder and Managing Director of propertybuyer, Sydney & Australia’s most awarded Buyers Agents. Propertybuyer helps property investors and home buyers search and negotiate the right property at the right price, everytime. For further details please visit www.propertybuyer.com.au or call +61 2 9975 3311 or 1300 655 615.
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Disclaimer: while due care is taken, the viewpoints expressed by contributors do not necessarily reflect the opinions of Your Investment Property.
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