Episode Details

A few months ago, a reader of this blog asked me to analyse two options. Option one is to borrow more money to fund an upgrade of your family home and consequently enjoy tax-free capital gains. The second option is to invest in property. The reader wanted to know which is the best option, net of all taxes such as capital gains and land tax?

Widen the scope of the question

I’d like to widen the scope of this question and add one more option – investing in shares. I have concerns with investing large amounts of borrowed funds in the share market, which I will discuss below. However, as an independent financial advisory firm, it is important that we always provide a balanced view – even if some of the options we are comparing are more of an academic comparison, than a practical one.

Interest rate assumption

One of the key assumptions in my financial modelling is interest rates. Normally, I like to adopt a conservative long-term interest rate assumption of 6.5% p.a. However, I realise that this might be less appropriate when interest rates around the world are making their way to zero (or are already there) and central banks are pursuing quantitively easing. It is very likely that interest rates will remain persistently low for an extended period of time. That said, it’s also not impossible that interest rates will rise sometime in the future too.

As such, in this analysis I have assumed that the variable interest rate is 3.7% for investment loans and 2.9% p.a. for home loans and will remain at this level for the next 3 years. I have then assumed rates will rise by 3% p.a. over the following decade (on a straight-line basis) and remain at that level.

What is most important is that I have used the exact same assumptions when comparing all options.

The quantitative analysis

I financially modelled three scenarios:

Option 1: Borrowing $1 million to fund a home upgrade from $1 million to $2 million. This allows you to move to a superior location thereby enjoying a superior capital growth rate.

Option 2: Borrow $1 million to invest in a property that generates gross income of 2% (rental yield before expenses) and capital growth of 7% p.a.

Option 3: Borrow $1 million and invest in shares which generate 4.0% p.a. in dividends (40% franked) and 5.0% p.a. in growth rate (so that the overall return is the same as the property option i.e. 9% p.a. – to ensure the comparison is fair).

As you will see from the chart below, option one is superior as it results in a higher net worth in today’s dollars. Options 2 and 3 are broadly similar.

A

It is interesting to observe that the higher expenses associated with property (e.g. maintenance, land tax, etc.) do not have a material impact. One might expect that the higher expenses associated with property investing compared to the higher income from share investing (particularly franking credits) would result in the shares option being superior. But the higher (compounding) capital growth from property more than offsets its lower income and higher expenses. The key here is investing in the right property i.e. investment-grade.

Home loan debt is less of a problem whilst rates are low

One of the problems with a strategy that gives rise to high amount of non-tax-deductible debt (i.e. home loan) is that it can be very experience. That’s because the interest is not tax deductible – so repayments are made from after tax dollars. In a high interest rate environment, this can absorb all cash flow thereby retarding your ability to make material loan