Debt strategy : When does debt make sense?

Financial Recovery

I believe that debt if addressed intelligently, is an excellent strategy to consider writes Peter Horsfield CFP, founder of SMARTadvice.

Here are some of the following examples where I believe debt is appropriate.

  • The investment must be either neutrally geared or positively geared if a valid financial reason to borrow and invest is to be considered. This allows the investor/borrower to either have exposure to the asset class i.e. property or shares without requiring ongoing cash flow to top up shortfalls by the borrower.

Take the net income (gross income less all expenses) earnt from the investment. Divide the income by the interest you will be paying. For example if a property is worth $500,000 and is rented for $26,000. Holding costs are calculated to be $4,000pa (rates, insurance, management fees, strata etc). If the loan interest is 5% then divide this by $22,000 ($26,000 gross rent less $4,000 expenses). The loan amount therefore for this property investment to be neutrally geared is $440,000. For this investor to have no additional ongoing out of pocket expenses $60,000 deposit is required (plus purchase costs & stamp duty). Note the investor should also be mindful of the opportunity costs (lost/gained) of their deposit & fees as they are now tied up within the one investment.

  • Another consideration in using debt to create wealth may be to advance one’s career i.e. for further studies. If one’s university or business studies cost $50,000 and 100% is borrowed for this. The question you need to ask yourself is how much will the additional expense and new knowledge gained from the studies improve one’s earning capacity from gaining higher qualifications? $10,000 per year, $20,000 per year, or more?

Considering a career/business future may be another 20-30 years. If your income increases by $15,000 per year from a more specialist role, or you can qualify for a higher pay grade, then over the space of 20- 30 years your return on investment would be over $300,000- $450,000. In this light I believe borrowing to invest in your own career, intellectual advancement or greater business income whilst still a debt, it’s definitely a better debt than a worse one.

  • Debt for an investment property improvement. Whilst being mindful to not over capitalise. If the improvements were to cost $30,000 for new carpets, paint, kitchen, bathroom, or maybe an extension i.e. extra room and because of these improvements the borrower/owner is able to charge a higher rent let’s say $100 more per week or $5,200 per year. If one borrowed only $30,000 and the interest rate was 5% i.e. $1,500 per year, then through this strategy incoming cash flows have increased by $3,700 per year from previously and potentially also increased the capital value of the property at the same time.
  • If a business owner embarked on a business expansion plan through either the purchase of another business or business machinery and this acquisition led to a increased business income/ profits, similar to the above example, if a business borrowed $100,000 to purchase another business and the interest cost to borrow was 10% i.e. $10,000 however because of the new business purchase (after any additional expenses such as staff, rent, utilities, stock) was to generate an additional $30,000 in gross profit per year to the business. Then the net business additional profit and cash flow to the business would be $20,000 i.e. $30,000 profit less $10,000 loan interest = $20,000 increased cash flow. As long as the borrowing and investment generates an improved cash flow, borrowing to invest is a strategy with intelligence.
  • Debt can also make sense if you were to refinance the debt to a lower interest rate i.e. an interest free or low interest balance transfer on your credit card, other loan. The advantage is that after the refinance less interest outgoings is the result, therefore real dollars being paid out in interest on one’s existing credit card would reduce. However the temptation must be resisted to just pay the minimum balance. To remove this worse debt ASAP one should continue to pay the same interest repayments as previously. Ultimately with the debt gone one now has the additional cash flow that can be used to add to one’s savings or make other investments.
  • The final consideration I would give to where it makes sense to be in debt is if the property you are intending to live in, and the loan and outgoings you have projected to pay are less than the current rent and out goings you are paying now. In this situation I would encourage one to use any additional monies one has to reduce the debt. As an alternative to simply paying rent in this situation the borrower would be exposed to an asset class that has potential to grow, whilst at the same time ensuring a roof is over the borrower’s head.'

Peter founded SMARTadvice with the desire to deliver both tailored and effective financial planning advice for individuals with inbuilt flexibility and value.

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