Warren Boland recently interviewed the author of a book called How to Create Wealth for Life by Tony Melvin and Ed Chan. I guess that we all want to 'Create Wealth for Life', as the book has created a deal of interest.
The basis of the book is that you can borrow to invest and, if you borrow a relatively large amount to invest in property, and property assets grow in value over time by seven per cent a year, then you will have a very positive investment experience.
All this is true; however there are other issues to consider such as:
- What if interest rates rise sharply to, say 15 per cent? (this has happened before under both Liberal and Labor Governments)
- What if property prices do not increase in value by seven per cent a year? (seven per cent is four per cent above the current rate of inflation of about three per cent - this is a big assumption to think that property will grow at more than twice the rate of other goods and services)
In the following article I have a look at the strategy of borrowing to invest. The strategy potentially works for all growth assets, be they shares, property or listed property. Indeed, the strategy may well work best with diversification amongst growth asset classes! I have specifically referred to borrowing to invest in shares, as there is more precise share data available than property data, and we can see exactly when borrowing to invest has created wealth - and destroyed wealth.
Borrowing to invest is a strategy that you need to be very cautious about - as there are risks that you must understand before 'launching in'.
The Basics of Borrowing to Invest
Despite the previous comments, the strategy of borrowing to invest may still be worth considering for your own situation.
When you consider borrowing to invest, the borrowed money generally comes from one of three sources:
1. a margin loan, which is a specially designed loan for borrowing to invest in shares and managed funds;
2. borrowing against the equity in your own home;
3. of, if you are borrowing to purchase an investment property, then as a mortgage against the property.
Generally people borrow to invest either in investment properties or in shares. In both cases people are hoping that investing using borrowed money will increase their overall investment returns.
The generic warning that comes with most borrowing to invest products is that 'as well as magnifying positive returns, borrowing to invest will also magnify losses'. That is, if the investment performs poorly you will lose even more money than if you had not borrowed to invest.
This is the crux of borrowing to invest. On average, it increases your investment returns while increasing the volatility of your investment portfolio.
To illustrate both the good and bad of borrowing to invest let us use examples from actual investment returns over time. While the example used is an investment in the Australian Share Market, the same principals apply to an investment property.
Usually you can borrow an average of around 65 per cent of the value of shares, and up to 75 per cent. So, if you had a portfolio of stocks worth around $100,000 then $65,000 of this could be financed by a loan. I often hear from financial planning commentators that a loan to value ratio of 50 per cent is a 'conservative' level of borrowing. I think a conservative loan to value ratio is about 33 per cent. This is effectively a debt (loan value) to equity (own money) ratio of 50 per cent - similar to the level of borrowing that many companies target. I also hesitate to use the term 'conservative' with borrowing. The very nature of borrowing to invest means that it is not a conservative strategy.
Example 1 - Borrowing to Invest Destroys Wealth
For this example let us assume a loan to value ratio of 50 per cent and put together a geared portfolio of Australian shares starting in July 1970. We will start with $50,000 cash and borrow $50,000 against some property that we own.
We will assume that the interest rate on the loan is 1.5 per cent above the cash rate for each year. So, in 1971 the cash rate was 5.7 per cent. We will assume that the rate we could borrow at was 7.2 per cent. This 1.5 per cent borrowing premium approximates what the banks are currently charging.
So, in July 1970 we started with a $100,000 share investment. The interest rate was 7.2 per cent so, on the $50,000 loan we paid $3,600 in interest. The sharemarket return for the year to June 1971 was -13.5 per cent so our investment lost $13,500. At the end of the year our investment was worth $82,900, that is $100,000 after paying $3,600 in interest and losing $13,500 in value. If we sold our investment right then and paid out our investment loan our ending balance, or what I have called our equity, would be $32,900. If we had just invested the $50,000 cash, the value of the investment would have fallen by 13.5 per cent, or $6,250, and we would have been left with $43,750. Clearly borrowing to invest has magnified our losses.
There were a few rocky years from there. The year to June 1972 provided a close to average return of 12.1 per cent, with the year to June 1973 providing a disappointing return of -9.1 per cent and the year to June 1974 a return of -27.3 per cent. The year to June 1975 saw the start of a recovery and provided a return of 8.4 per cent.
So how did our portfolio stand up to this rocky period? By June 1975 our $100,000 investment had decreased to $51,600. So, after paying off our $50,000 loan we would be left with $1,600. That is, our original $50,000 of 'equity' was now worth $1,600. If we had not borrowed any money, and just invested the $50,000 in Australian Shares then the we would have been left with $34,731. We have significantly magnified our losses.
I extended this model all the way through to June 2005 and at no point in time was the geared investment portfolio worth more than the straight $50,000 sharemarket investment. By 2005 the equity in the geared portfolio was worth $842,775 and the portfolio where $50,000 was invested without any borrowed money was worth $2.048 million. The first five years of poor investment returns in the period we looked at destroyed so much value in the geared portfolio that it simply never recovered, even over a 35 year period which included some tremendous years of strong sharemarket returns.
Example 2 - Borrowing to Invest Creates Wealth
Now, to show another example let us assume that we started in July 1975 with $50,000. Just as in the example above let us assume that there are two scenarios, one in which we borrow $50,000 to put with the $50,000 and build a $100,000 investment portfolio, and the other where we invest the $50,000 straight into the Australian Sharemarket.
In the first year the return on Australian Shares was a strong 32.2 per cent. In the portfolio using borrowed money the investment return was $32,200 with interest on the loan being $5,150. So, by the end of the year the portfolio was worth $127,050 and our equity in the portfolio, if we subtract the $50,000 loan, is $77,050. The $50,000 portfolio had increased by $16,100 to $66,100. So, the strategy to borrow money had increased our financial position by $10,050 in one year.
The next four years of returns on the Australian Sharemarket were 1.5 per cent, 6.7 per cent, 26 per cent and 74.3 percent. After this period of time the portfolio using borrowed money had increased in value to $258,338. So, after deducting the $50,000 loan our equity is worth $208,338. The value of the portfolio of the $50,000 invested in the Australian Sharemarket had increased in value to $157,217. So, over five years the strategy of borrowing to invest was worth a little over $51,000.
In 2005, 30 years after starting these two portfolios, the value of the $100,000 portfolio that used borrowed money was $3.7 million (after subtracting the $50,000 loan) and the portfolio started with the $50,000 was $2.95 million. In this case the strategy of using borrowed money to invest seemed to pay off.
If you started a geared portfolio in either 1987 or 1988 (even after the sharemarket crash in 1987), using a geared investment strategy as described above, you would be worse off even today than if you had simply invested your money without borrowing any money.
Longer Term Data
For a masters thesis I used historical sharemarket data stretching back to 1900. Each year I compared the results of investing a portion of a person's income into the share market each year while borrowing a similar amount of money to invest. The portfolios were built over a 40 year period. Even with such a long period of time in the market, in 20 per cent of the cases borrowing money resulted with a decreased ending portfolio balance compared with simply investing money with no borrowing.
While it seems that I may have gone out of my way to show that borrowing to invest does not always pay off, I hope that stands as a counterpoint to the common idea that borrowing to invest over the long term is a certain strategy to increase your wealth.
The Added Problem of a Margin Call
In the examples I have discussed previously, I have assumed that the borrowings were secured against real estate. However, in a lot of cases a margin loan is used.
A margin loan allows borrowing against shares, up to a maximum limit. That limit is expressed as a ratio of the loan to the value of the shares. For example, if a share has a loan to value ratio of 70 per cent, the margin loan will allow you to borrow $70,000 of a total holding of $100,000.
Of course, if the value of the investments falls, the loan to value ratio will increase. Once the loan to value ratio increases above the allowable level the investor has to either sell some assets, add some cash to the portfolio or put forward additional assets as security for the loan.
The problem is that if you are forced to sell some assets because of a margin call it is usually at the worse time to do so, when markets have fallen sharply.
In our example, even a 'conservatively' geared portfolio would have faced margin calls in the period in the early 1970s and late 1980s. In fact, in the early 1970's you would have expected to have had to sell your entire investment portfolio at significant losses.
Once you have paid off your home loan, redrawing against that may be a better option as there is no chance of a margin call and interest rates are often lower than for margin loans.
Do You Need to Gear?
The fact that borrowing to invest increases both the riskiness and return of a portfolio paradoxically makes it unsuitable to help the people who need it most. That is, if you are ten years away from retirement and well behind in your retirement goals, it might be very tempting to borrow some money to try to increase the returns you get from your portfolio. However, if returns were poor it would put you in such a difficult situation financially that the extra risk inherent in the strategy does not make it worthwhile.
For people further from retirement it is worth considering whether you even need to borrow to invest to meet your financial goals. You can assess this using investment calculators such as those found on the FIDO section of the ASIC website (www.asic.gov.au). If you can reach your financial goals without borrowing to invest, it is worth considering whether you want to take on that additional risk.
The Tax Advantages of Gearing
There is a tax benefit in borrowing to invest, called 'negative gearing'. Negative gearing refers to the situation where the income from the investment is less than the expenses of the investments. In this case the loss can be used to reduce a person's taxable income.
For example, if you owned an investment property that produced income of $10,000 with costs of $15,000 in interest payments, $2,500 in body corporate fees and $1,500 in rates, the property would give you an annual loss of $9,000. This loss can be used to reduce your taxable income and therefore the tax you have to pay.
Taking a Cautious Approach
As well as using a conservative loan to value ratio, a number of other precautions you can take will decrease the risk of gearing. These strategies include:
- having suitable income protection insurance, so that if you become ill or disabled and unable to work you have a replacement income that will means you will be able to maintain your geared investment, without having to sell it suddenly;
- paying the interest on the loan from your salary, so that the value of the loan does not keep increasing though having the interest added to it;
- having a strategy to pay off the loan at some stage.
The 'Double Whammy' of an Interest Rate Rise
If interest rates rise, an investor who has borrowed money is hit by two negative effects. The first is that their loan repayments will increase. The second is that as interest rates rise, asset prices, either property or shares tend to decrease. Whether it is a share portfolio or an investment property, an interest rate rise will be unwelcome for an investor who has borrowed to invest.