Utilising debt to invest
Many people will tell you that debt is bad and should be avoided at all costs. While this may be true in many instances, debt can also be a very powerful tool to help accelerate your wealth creation and form part of your investment strategy.
In the context of investing, debt can come in many forms; investment property mortgages, equity in an owner occupied mortgage used for an investment purpose, margin loan, debt instrument/fund managers/ETF’s that incorporate debt, etc.
When utilsing debt to invest, there can be a variety of benefits:
One such benefit is having the ability to purchase an asset that you otherwise would not be able to afford. A very topical point at the moment is around affordability of property for first home buyers – imagine how much more difficult that would be if you needed to save up 100% of the property value! The utilisation of debt allows the vast majority of property investors to purchase into this asset class.
In addition to this, the interest that is paid on the debt associated with an investment asset is also tax deductible. Hence, people have used strategies such as negative gearing.
Debt also has the ability to magnify a person’s gains. For instance if you are investing in a share portfolio with $50,000 and that asset was to increase by 10%, you would have made $5,000. However if you were to take out a margin loan and the total asset base was equate to $100,000, a 10% rise in that asset would return $10,000.
Many people will also utilise debt to be able to stretch their investment reach. By incorporating debt into their investments, this increases the amount of funds available to invest and can allow the investor to invest or more than one asset allowing them to diversify.
While debt can be a very powerful and sometimes necessary aspect of your investment strategy, it can also come with additional risks:
In the above example of how debt can magnify gains, it also has the ability to magnify losses in times of uncertainty. In this situation of magnifying losses it can also mean that you stand to loses more than just your initial investment, as your debt amount is also exposes to market fluctuations.
The interest that is associated with the debt can eat into the profits of your investment and even your current cashflow position.
When utilising debt products such as margin loans, you can also be at the risk of margin calls.
Given that there is interest associated with the debt you are holding, your break-even point for the investment that you are investing in will increase.
A rise in interest rates could negatively affect your cashflow and the net investment performance.
Careful consideration should be taken when you are utilising debt for an investment purpose and it is important to ensure that there is a repayment strategy, prior to entering into such an arrangement.
Additional it is important to consider not only the cashflow if things were to go as planned, but also in the instance of unexpected events such as a rising interest rates, loss of job, injury or illness, etc. Hence an insurance and cashflow plan should also go hand in had with any debt strategy. Some other things to consider may be to explore fixed interest rates to help reduce interest rate risk and consider your Loan to value ratio as well as long term investment strategy.