When you hear the word debt, you may not immediately think of it as a money-building strategy. Quite the opposite, in fact: most loans are a huge drain on your finances.
But certain kinds of debt can actually help you build wealth. Gearing, or the practice of borrowing money to invest alongside your own capital, is a strategy many people use to maximise their investments.
Let’s look at three examples of how you can use debt to build wealth:
- Borrowing to invest
- Instalment gearing
- Debt recycling
Borrowing to invest: Katie
Katie has $200,000 she’s ready to invest. But she wonders if it would be better to borrow another $200,000 so she can invest $400,000.
Before deciding, she needs to take a few things into consideration:
- Her investment return is 7.5% (5% growth and 2.5% income)
- The interest on her loan is 4.49%
- She’ll re-invest her investment income and her tax savings
- Her marginal tax rate is 39% including the Medicare levy
Based on these details, let’s look at the results she’ll get if she only invests her own $200,000, vs if she borrows an additional $200,000 to invest.
| $0 borrowed | $200,000 borrowed | |
|---|---|---|
| Own Capital | $200,000 | $200,000 |
| Borrowings | — | $200,000 |
| Total Investments | $200,000 | $400,000 |
| Plus Returns (7.5%) | $15,000 | $30,000 |
| Minus Interest on Loan (4.49%) | — | $8,980 |
| Plus Tax Saving (39%) | — | $3,502 |
| Net Investment Value | $215,000 | $424,522 |
| Minus Borrowings | — | $200,000 |
| Minus Own Capital | $200,000 | $200,000 |
| Total Net Return ($) | $15,000 | $24,522 |
| Total Net Return (%) | 7.50% | 12.26% |
If Katie only invests her own capital, she can expect to make $15,000 for a 7.50% total rate of return, whereas if she borrows another $200,000, she can expect to make $24,522 for a rate of 12.26%.
With those results, it makes sense for Katie to borrow the money to invest. She’ll be able to pay back the loan and still make $9,522 more than she would have with merely her own capital.
Instalment gearing: Steven
Steven wants to start a regular savings plan. He has a lump sum of $10,000 and can afford to invest $2,500 more per month.
After giving it some thought, he decides to borrow and invest another $10,000, then $2,500 each month to match his own contribution.
Let’s assume that:
- His investment return is 7.5% (5% growth and 2.5% income)
- His franking level is 50%
- Interest on the loan is 4.49%
- He’ll reinvest his investment income and tax savings
- His marginal tax rate is 39%, including the Medicare levy
Steven continues to follow this savings plan for 10 years. At the end of that time, his investment portfolio is worth about $896,424. Without the money he borrowed, it would be worth only $433,922.
Of course, he does have to pay back all that money he borrowed, and he also has to pay taxes.
After repayment and taxes, his portfolio will be worth about $568,257, whereas if he hadn’t borrowed, it would only be worth $422,131. So, instalment gearing helped Steven make an additional $146,126.
Debt recycling: Angela and Teresa
Debt recycling is the process of converting inefficient debt to efficient debt.
For example, you might use your investment income and capital gains to reduce your mortgage. This gives you more home equity, which you can then use as security to borrow more money to invest. With the income and capital gains generated from that income, you can reduce your mortgage again, and so on.
This strategy may be a good idea if you’re trying to pay off your mortgage faster and build your investment portfolio sooner, but it isn’t for everyone. Before trying it, make sure that:
- You have enough home equity that any additional investment loan won’t trigger your mortgage insurance (usually this means you have 80% LVR)
- You have a line of credit that can act as a flexible investment loan
- You have a surplus income that will support the investment loan interest payments
- You have enough experience and risk level to build an investment portfolio
Let’s look at an example.
Angela and Teresa have a house worth $1,200,000.
Their mortgage is as follows:
- $350,000 principal
- 30 year loan term
- 2.59% interest rate
- $1,399 monthly repayments
Angela makes $110,000 a year and Teresa makes $85,000. Together, they have a total surplus income of $2,000 per month after taxes.
With that surplus, they’re trying to decide between making additional loan repayments or funding a loan for investments.
Currently, if they pay off their mortgage in 30 years, they’re looking at $153,768 in cumulative interest. If they make the additional repayments that their surplus supports, they could pay that off in 9 years and 9 months, with $46,253 in cumulative interest. That saves them $107,515 and allows them to pay off the mortgage about 20 months sooner.
Now, let’s look at what will happen if they use the surplus for an investment loan.
With $2,000 a month, they can fund a loan of $240,000 with a term of 10 years. Let’s say they use that to invest in a portfolio under Angela’s name, with:
- An investment return of 7.5% (5% growth and 2.5% income)
- A franking level of 50%
They then re-invest their income and tax savings. (Angela’s marginal tax rate is 39% including the Medicare levy.)
After 10 years of doing this, their portfolio will contain $433,068. And assuming they’ve continued making the $1,399 monthly repayments on the mortgage, their mortgage balance will be $261,071.
By this time, they will have paid off the investment loan. They can now use the $433,068 in their investment portfolio to pay off the rest of their mortgage—and still have $171,997 left over.
Clearly, it makes more sense for Angela and Teresa to use their surplus income to fund an investment, then engage in debt recycling to pay off their mortgage and build their investment income at the same time. Not only do they pay off their mortgage sooner: they end up with a profit of $171,997.
Using debt wisely
Of course, while borrowed funds can magnify your gains, they can also magnify your losses. That’s why you’ll want to choose your investments carefully and weigh the potential risks of borrowing money to invest.
Learn more about how to build your investment portfolio and sound investing practices.
