Episode Details

Borrowing to invest, particularly in property, has been a very popular investment strategy in Australia. A mortgage is a wonderful servant but a terrible master. If you use mortgages properly, in a risk adverse way, it can be a very powerful wealth accumulation tool. However, if used poorly, it has the power to destroy more wealth than it creates. After almost 18 years since establishing this firm, I thought it was timely to share some insights and observations about borrowing to invest.

Inflation will eventually eat away at the value of debt over time.

Interest rates reflect inflationary expectations. That is, when inflation expectations are high, so are interest rates. As such, borrowers are paying for the inflationary cost of debt each year. This is evidenced by the fact that a loan’s amount does not change from year to year. If you borrow $200,000 today and don’t make any principal repayments, in 20 years’ time you will still owe $200,000.

But we know that over time, due to the impact of inflation, our purchasing power reduces. A $200,000 loan in the mid-1980’s was a big deal. Today, it is considered a small loan. Whereas a loan for $1 million today is regarded as a big loan. However, in 20 years, a $1 million loan will be equivalent to $670,000 in today’s dollars (assuming an inflation rate of 2% p.a.). And only $550,000 in 30 years.

Because interest rates include the cost of inflation, and investors pay for that each year, in real terms, the value of their debt reduces over time.

It magnifies your return on equity

Using some borrowings to fund the acquisition of an investment means you can contribute less of your own cash. For example, assuming interest rates are 5% p.a., if you contribute 60% of a property’s price in cash (and borrow the remaining 40%), I estimate the investment will be break-even from a cash flow perspective. That is, the rental income should be enough to pay for the property’s expenses and interest costs.

If you retain this $750,000 property for 20 years and it appreciates in value by an average of say 7% p.a., it will be worth circa $2.9 million. I estimate that the investor would crystallise approximately $2.05 million of cash after selling the property (net of costs, repaying the loan and CGT) after 20 years. So, the initial cash contribution of $450k (60% of the purchase price) has grown to $2.05 million after 20 years. That equates to a compounding annual growth rate of 7.9%. Without any gearing, the net return would have been only 5.9% p.a. So, the existence of a modest gearing rate (40%) has increased the investors return on equity by 2% p.a. This is the power of gearing.

Return on cash is even more impressive

What if you don’t contribute any of your own cash savings when you purchase the property? That is, you borrow the total cost. In this situation, your only cash contribution will be to fund the holding costs. That’s because if you borrow 100% of the acquisition costs, the property’s income will probably not be enough to pay for its expenses and loan interest. As such, you will have to contribute some of your salary income towards meeting these expenses.

I estimate the cash flow holding cost of a $750,000 property to be conservatively circa $175,000 after-tax over 20 years. If you sell the property after 20 years, you will walk away with $1.58 million in cash after repaying the loan, selling costs and CGT. Therefore, your cash contribution of $175,000 over 20 years has generated net cash gain of $1.58 million. That equates to an annual compounding rate of return of 11.6%. That is referred to your return on cash, since you didn’t contribute any equity (cash) at the beginning.

Gearing allows you to invest your future income today

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