40 MONEY AUGUST 2016 MONEY AUGUST 201641

COVER STORY PAY OFF THE MORTGAGE OR INVEST

Investing instead of paying off debt is, in effect, a decision to have more debt than would otherwise be the case. The more debt you have, the riskier

your situation is. So the first question you really need to answer is: what’s an appropriate level of debt for your personal situation? Unfortunately, Australian households are the most indebted in the world and this has led to a pretty casual approach when it comes to assessing what is a reasonable amount of debt to be carrying.

Variables that will determine appropriate debt levels include age, current and future income, health, current and future tax situation, retirement goals, job security and, of course, tolerance of risk. These factors can be

return increases from 6.67% to 8.91%pa, or 2.4% higher than paying off the mortgage.

Other ways to borrow to invest are: Margin loan This allows you borrow money to invest and uses your shares or managed funds as security. The lender will set a maximum loan to value ratio (LVR) which would commonly be around 70% of the value of the investment. If the value of the investments falls to a point where your loan is greater than the maximum LVR, you will be required to reduce your loan, sell part or all of your investment or give the lender extra security. This is typically known as a margin call. Margin loan rates are typically around 2% higher than home loan rates and usually have minimum loan amounts of $20,000. Instalment gearing This is like a margin loan combined with a regular savings plan. Instalment gearing plans start with a lump sum of typically $5000 or more. This amount is increased by borrowing money (typically the same amount as invested) so that the investment exposure is double the initial investment. As more money is added over time, so too is the amount borrowed. A big advantage is that you are acquiring units over longer periods, buying more units when prices are lower and fewer when prices are higher (dollar cost averaging).

Despite the diversification benefits, under most return and interest rate scenarios paying off non-deductible debt will be both more effective and less risky than a margin loan or instalment gearing. Unless you are

quite experienced I would not recommend these options.

Ben Graham, CFP and FPA member, is principal and financial adviser at Graham Financial, an independent financial planning practice based in Toowoomba. grahamfin.com.au.

COMPARE OUTCOMES: PAY DOWN MORTGAGE; PAY DOWN DEBT & INVEST; OR BORROW TO INVEST AND PAY TOTAL DEBT

DATE DO NOTHING USE $100PW TO PAY DOWN MORTGAGE, THEN INVEST

PAY DOWN MORTGAGE, BORROW TO INVEST TWICE, THEN PAY DOWN NON-DEDUCTIBLE DEBT

PPR1 DEBT NET WORTH (EX PPR VALUE)

PPR1 DEBT INVESTMENTS NET WORTH (EX PPR VALUE)

PPR1 DEBT INVESTMENTS DEDUCTIBLE DEBT

NET WORTH (EX PPR VALUE)

30-6-16 $400,000 -$400,000 $400,000 -$400,000 $400,000 -$400,000

30-6-35 $238,120 -$238,120 $80,739 -$80,739 $32,610 $414,557 $360,000 $21,947

30-6-37 $206,477 -$206,477 none $18,625 $18,625 none $527,352 $398,658 $128,694

30-6-46 none none none $464,237 $464,237 none $720,878 none $720,878

Assumptions: Value of home $520,000; average mortgage rate 6.5%pa; average investment return of 5%pa income (grossed up for franking) and 4%pa growth. 1Principle place of residence.

STORY BEN GRAHAM

Recycle debt to reduce the riskAs you pay

down the non-tax-

deductible home loan,

use your equity for an

investment loan where

interest is deductible

SUGGESTED INVESTMENTS

TOP ETF PICKS

• Vanguard MSCI Index International Shares (VGS)

• Vanguard MSCI Index International Shares (Hedged) (VGAD)

• iShares Core S&P Midcap ETF (IJH)

• SPDR S&P/ASX 50 ETF (SFY)

• iShares Core S&P/ASX 200 ETF (IOZ)

TOP SHARE PICKS

• Crown Resorts (CWN)

• CYBG (CYB)

• ANZ (ANZ)

• Medibank Private (MPL)

• Woolworths (WOW)How it worksCouple both aged 35 earning $60,000pa.House worth $520,000 with a $400,000 mortgage.Investment returns: 5% income (grossed up for franking) and 4% growth.Home loan rate: 6.5%.What can be done with $100 a week excess cash flow? How would this compare with just putting it on the home loan?My plan:Step 1 Initially pay down home mortgage debt to a more manageable level.Step 2 At June 30, 2020, their non-deductible debt should be about $357,000. At this point borrow an additional $40,000 (interest-only investment loan) out of the existing equity to make a share-based investment in joint names. Step 3 All earnings, tax savings and remaining cash flow to be used to pay down non-deductible debt.Step 4 When total debt is less than $360,000 again, repeat step 2Step 5 Once non-deductible debt is paid off, repay deductible debt.

The plan is not designed to maximise the financial outcome but to show what can be achieved by investing while overall debt is kept below your current levels.

difficult to quantify but there are some basic rules of thumb we use to determine whether you’re ready to consider an investment over paying off your mortgage (we assume you have no other debt or investment assets):

1Is your debt to equity ratio less than 100%? Calculate your debt to equity ratio by dividing your mortgage

by your equity, so if you have a mortgage of $400,000 and a house worth $700,000 your debt/equity is 133%.

2Is your interest cover more than two times? There are some nuances due to tax but this is your after-tax

income (say $100,000), less living expenses excluding the mortgage (say $55,000), divided by interest on your mortgage ($26,000), which gives 1.73 times. You need to factor in any likely changes to your income, expenses and mortgage rates. We would recommend using a mortgage rate more like 6.5%pa, even though rates less than 4%pa are available today, as current historic lows are not appropriate for longer-term planning.

3Do you have a cash buffer of at least 1½ years worth of expenses including the mortgage? This could be

held in an offset account attached to your mortgage. Arguably a cash buffer is the most important of all three measures. While you may be able to sell your investments in an emergency – such as a job loss – if it coincides with a market downturn (and it often does) you can become a forced seller at the wrong time.

In our case study (left), based purely on the rules of thumb, we would delay an investment and advise continuing to pay off the mortgage for the time being.

There are three factors that will determine whether you will be better off investing or paying more off the mortgage: current and future tax rates, investment returns and borrowing costs

When paying extra off your mortgage, your after-tax return is your mortgage rate and guaranteed. Over the long term this might average, say, 6.5%. When you invest this money instead, the after-tax return is calculated by the investment return less tax. So if investment returns are 9% and your marginal tax rate is 34.5%, your after-tax return will be 5.9%. However, if half the return was a capital gain eligible for the 50% discount, the result would tip back in favour of the investment – 6.67%.

Clearly investing works better if mortgage rates and tax rates are low and investment returns are high.

But is there a way of having your cake and eating it too? The short answer is yes, using a process called debt recycling. The interest paid on your family home loan is not tax deductible, whereas interest paid on loans to make income-producing investments are. So instead of using your excess cash flow to make an investment, you pay off your non-deductible debt. Using the equity you just created in your home, you can now borrow funds to make an investment.

In effect this process recycles non-deductible debt into deductible debt. In our example, using the same return and no net increase in debt, the effective after-tax