Foundations of a secure future

Debt is a four-letter word and never more so since the global financial crisis.

Australians are paying off their mortgages faster than usual, credit card spending is growing at half the rate of a year ago and margin loan balances are at their lowest in seven years.

In its latest report on the state of the financial system, the Reserve Bank of Australia notes households are taking "a less exuberant approach" to borrowing.

Advisers are happy to see any move away from "bad debt", or credit that's used to buy "the trinkets of life", as an accountant with Chan & Naylor, Ken Raiss, puts it.

But there's concern in some quarters that this aversion extends to "good debt" that is, borrowing to buy assets that (in theory) appreciate rather than depreciate.

"For me, the fear of debt is what's principally stopping people creating a financially secure future," Raiss says.

Others urge caution. The head of technical services for ipac Securities, Colin Lewis, says the financial advice firm has always had the view that you don't use debt to invest unless you absolutely must. "Our approach to debt has always been that you don't take on risk for risk's sake," he says.

IRRATIONAL EXUBERANCE

The idea is that debt leverages an investor's available funds into a bigger asset, then over time that asset grows in value while the debt remains static or even decreases in value in real terms due to inflation.

A financial planner with Ark Total Wealth, Chris Magnus, says that before the GFC people were much more optimistic - sometimes too optimistic - about debt and investing as a whole and "unfortunately, people were taken advantage of".

But debt still has a role to play today, he says, as long as investors are educated around the risks involved in gearing - in other words, taking on debt to multiply your investing power - and they take a measured approach, he says.

Lewis points to the example of the people who "double geared" in the Storm Financial debacle.

"Many of those people were sitting comfortably in their retirement situation. So why take on gearing just to try to hook into the [booming] market?" he says.

"Yes, gearing magnifies your gains, but it also magnifies your losses. If you're sitting pretty, why take on that additional risk? It becomes about greed." That said, some people just won't be able to meet their financial goals through mainstream means, such as superannuation strategies, and they might need to consider gearing, Lewis says. In this event, robust gearing rules are required, he says (see box above).

BUFFER IS CRITICAL

Safety first, then. And, with high investment market returns seemingly less assured, there's less room for error, so doing your sums is more important than ever. "The maths should always have been done but people don't in a rising market," Lewis says.

"What's happened is that the need to do so has been highlighted."

Magnus says people who borrow must understand the assets they're gearing into (and that includes the underlying assets that sit beneath a geared financial product) as well as the time frame required to achieve the desired outcome.

Promises of quick riches should ring hollow and investors must do their sums on realistic rates of return.

"The returns the sharemarket was achieving before the GFC were a once-in-a-lifetime event," he says. "What the market has returned to is in fact normality." This means much more time needs to be spent researching and waiting for the right investment.

Magnus and Raiss say that in property, for example, people need to be able to identify not just the right building in the right location but also the right unit in that building. They need to consider how they can add value to the property so they achieve capital growth regardless of the vagaries of the market.

Having identified an opportunity, investors then need to consider how they'll structure the debt and manage the cash flows, Raiss says.

"It's all about creating a buffer," he says. "The buffer is critical if you have debt."

If a property is negatively geared with a shortfall of $10,000 a year, for example, and you lose your job or your tenants, the worst case is a forced sale in which you don't recoup your capital.

"But imagine if you had access to $100,000 equity in another property - it would last 10 years if you needed to draw on it," Raiss says.

Think about how many years of safety you need to sleep at night, he suggests. For some people it might be two years (so $20,000 in this example) for others, it might be seven - historically, one property cycle.

Every asset should stand on its own, Raiss says. "Do the numbers as if it's the first and last one you're buying."

TAX-EFFECTIVE STRUCTURE

Finally, let's look at a strategy that's been dubbed debt recycling or debt transformation. The idea is that you take on good debt to buy an asset that produces income and tax benefits that can be applied to eradicating bad debt, in the form of your non-tax-deductible home loan.

The managing director of mortgage management firm Australian Mortgage Options, Robert Projeski, provides an illustration. Say you have a $1 million home in Sydney or Melbourne on which you owe $400,000. You have a mortgage with an associated offset account.

You buy a $625,000 investment property, using an interest-only loan to borrow $500,000 - 80 per cent of the value, so mortgage insurance doesn't kick in. A further $125,000 is borrowed against your home, placed in a second offset account (so it's clearly separated from your non-investment finances) and used for the deposit. You now owe $1,025,000 on $1,625,000 of property, for an overall loan-to-valuation ratio, or LVR, of about 63 per cent.

Each month, all the income from the investment goes into the original offset account attached to the home loan.

Any tax refund generated by the investment costs also goes into this account.

The bulk of your wages can also be put to work in this account if you use a credit card for living expenses, clearing it at the end of the month.

You could also seek a tax variation so you pay less income tax each month, rather than annually, leaving more to go into the account.

Money comes out of the offset account to meet the interest payments and other expenses related to the investment.

But, if you have bought well and done your sums, there should be enough left over for the offset balance to gradually build to the point where the home loan is cleared, Projeski says.

Now there's only tax-deductible "good debt" and the cash flow that's freed up can be applied to that debt or to another investment (property or otherwise).

In the meantime, you have started investing earlier than you might have if you'd waited to clear your mortgage first, gaining the advantage of time.

Asked for his view, Lewis says debt recycling can work but you must get the cash flows and structure right so you don't attract the ire of the Tax Office. In other words, don't try this on your own - get expert tax and financial advice.

Dont be blinded by tax benefits

A state manager with Heritage Bank by day, Paul Moses is a long-time property investor after hours.

Moses borrowed to buy his first investment property at 21. He has bought and sold several properties throughout the years and now has his own home plus three others.

However, he says his approach has changed slightly in recent years.

Until now, his properties have been negatively geared, with outgoings such as interest payments higher than the rental income.

But his focus moved to rental yield rather than prospective capital growth with his two most recent purchases in the NSW regional towns of Moree and Dubbo last year.

"[They] are purely for positive gearing, more so than capital growth," Moses says. While they're negatively geared now, his aim is for them to be in the black within a year or two.

"I can get my hands on more property and I have the ability to repay the debt if I have a high yield," Moses says.

"Whereas if I go for capital growth, I might have to borrow a lot of money for a property in a quality area where the rental returns aren't enough to sustain the repayments."

Everyone seems to want to negatively gear, Moses says, "but unless you are confident in making a strong future capital gain, I don't see the point in losing money just for a tax benefit".

Do the maths before you borrow

Money asked ipac securities to run some numbers that would illustrate what sort of return you might need for a gearing strategy to break even.

We assumed that $100,000 was borrowed at a rate of 7 per cent, most likely in the form of a home-equity loan. (A margin loan would cost about 9 per cent.) This was invested in a portfolio of Australian shares (70 per cent franked) for seven years.

To take one example from the table: if you were on the top tax rate and this notional portfolio had an overall dividend yield of 3.5 per cent, you'd need share-price growth of 1.8 per cent a year to break even.

But if share prices rose just 1 per cent you'd be $5000 behind.

Conversely, at 3.5 per cent share-price growth a year, your profit would be more than $11,000 even after income tax and capital gains tax.

Choose higher-yield stocks and the break-even point is easier to reach and the potential gain higher.

Guide to responsible investing

Ideally, you should be able to answer yes to all these questions before going into debt:

- Is borrowing the only way for me to achieve my financial goals?

- Do I have a time horizon of at least five, preferably seven, years?

- Do I have a steady income to fund the borrowing costs (not just dividends or distributions)?

- Could I still afford the repayments if interest rates were 3 percentage points higher?

- Do I have insurance to protect my income?

- Looking at my overall portfolio, do I own at least 50 per cent of the assets?

- Have I considered the quality of the investment, not just the tax deduction?

Source: ipac securities

Line-of-credit loan disastrous

Good debt turned bad for Pix Jonasson when she and her former husband borrowed to invest in a business and four investment properties.

They borrowed $675,000 in 2008 and "everything was going swimmingly" until the mortgage-broking business they had invested in part of a chain that had been named as one of Australia's fastest-growing franchises went bust in 2009, at a loss to them of $200,000.

"The GFC didn't help," she says.

Jonasson says they called on their bank's branch manager to assure her that while things were "tight", they could still service their debt.

They also told her they would make plans to sell the investment properties and Jonasson says she seemed comfortable with that.

"But in July 2010, the bank hierarchy in Sydney just chose to raise the interest rate on the line-of-credit loan from 6.86 per cent to 17.49 per cent," she says.

"That sent us to the wall. I had to sell my principal place of residence."

One investment property, funded through a separate loan, is still holding its own, she says.

Jonasson and her former husband have been in dispute with the bank over how all this was handled but, perhaps surprisingly, Jonasson says it hasn't put her off borrowing to invest again at some point.

"I've learnt a lot but I'm not bitter and twisted about it," she says. "I'm a more savvy investor though unfortunately I don't have the capacity to invest just yet."