Debt: leveraging ‘good’ debt and minimising the bad
What do we mean by ‘leverage’?
Leveraging, in financial terms, involves borrowing. For example, if we buy a house with a 20% deposit, then we ‘leverage’ 80% when we borrow from the bank. This leveraging is called ‘gearing debt’. As mentioned in the section on Cash flow, debt itself can be fine. It all depends on what kind of debt you have – and on how you work that debt to your advantage.
How do we win with leverage?
We win with leverage when we make it tax effective. Leverage is about borrowing in such a way that your profit from the investment outweighs the interest you have paid. It can also be used for investment properties or shares. Gearing debt can be a wonderful tool to accelerate your wealth when used properly.
About your home loan
Interestingly, many of us are comfortable to have a mortgage on our home. The attitude is: “Isn’t this great? It’s saved us rent!”.
A home mortgage is not the worst kind of debt, but…
A home mortgage is not tax deductible. It’s also not flexible and it is not very liquid. You can’t, for example, sell a bathroom if something goes wrong and you need extra cash. Also there are many additional non-deductible costs (e.g. insurance, rates, maintenance and beautifying costs). There is also the leverage ratio to take into account. If you have paid, for example a 20% deposit. This means you are leveraged to 80% and are paying interest on the amount that you borrowed.
3 different types of debt:
1. ‘Clean’ or good debt
Tax deductible debt, e.g. profitable shares, good investment properties.
2. ‘Dirty’ or bad debt
This debt is not tax deductible (also known as ‘consumer debt’), e.g. credit card debt.
3. Neutral debt
This is somewhere-in-between debt, e.g. buying your home
Gearing strategy tips
1. First, always be clear on the amount you have to invest
2. Always pay out your bad debt first
3. Use a good debt strategy to accelerate paying off neutral debt
4. Make sure that your cash flow isn’t affected by your investment
5. Ensure you can service the debt if interest rates go up
Utilising leverage will help you:
• Maximise the use of your current resources
• Get to your goals more quickly
• Create and achieve bigger goals
Getting leverage can be like finding the transit lane at peak hour
You start moving a lot quicker than everyone else around you. Meanwhile, the other drivers are cursing and frustrated. They move slowly as you speed by.
Case study: Owen & Tom
Owen and Tom* are brothers. In many ways their lives are identical:
• Both earn $70,000 a year
• Both own a house worth $500,000
• Both have a mortgage of $150,000
• Both have equity: $350,000
Owen pays off mortgage at $1,195 p/month, and owns his house outright in 19 years. Being more investment-savvy, Tom does the following:
- Borrows $200,000 against the equity of his home
- Establishes an investment portfolio
- Gets an investment loan, pays interest only
- Increases loan repayments to $2,362 per month
Tom also owns his house in 19 years.
So what’s the difference?
Tom’s ‘smart debt’ then kicks in:
• The interest on the money borrowed is tax deductible (so Tom’s annual income tax is reduced by $2,500)
• Receives annual dividends of $5,000 a year from his investment portfolio (dividends are franked, i.e. tax already paid)
• Deducting 1.5% for management fees, in 19 years the portfolio is worth $888,446 (initial investment: $200,000)
Tom is $598,000 better off than Owen
*not their real names