Nigel Baker has been advising private clients for over 20 years. He is a Chartered Accountant, Certified Financial planner and registered tax agent. After running the Sydney wealth team for one of Australia’s largest accounting firms for 10 years, he started his own private wealth practice, Arch Capital, 10 years ago and founded digital advice business scientiam.com.au. He is also the author of “the Super-Secret”.
Average house prices have been soaring in many parts of Australia. The cost of living is skyrocketing. And we are seeing many people taking on debt to fund their lifestyle.
In the low-interest rate environment and high house price climate Australians now face, there is a tendency to take on amounts of debt that not so long ago were unthinkable.
It can be very daunting once you are on the debt “merry go around”, and if you are already facing pressure from other aspects of your life, high debt can just be “the hair that breaks camel’s back”.
The hidden cost of interest rates
When interest rates are near zero percent, there is a tendency to not worry about debt perhaps as much as we should.
But it’s important to be careful with debt – low rates are unlikely to remain in place forever.
We all have parents or relatives who talk about the days when interest rates were 17% right? While it’s unlikely that rates will reach these heights again soon, even an increase of 1% or 2% can drastically change the cash flow of individuals. For example, the interest repayments on a $1m mortgage are currently around $20,000 per annum. If rates go up by 2%, the interest-only repayments will be $40,000 per annum. This is a big cash flow difference. Will this put pressure on the household budget? Absolutely.
Throw in a life event like sickness, loss of job or relationship breakdown and the financial issues will flow on to personal and psychological areas.
In my twenty years of giving financial advice, here are some common questions I have often been asked around debt that may help you navigate this area of your finances.
Is all debt bad?
Not necessarily. Borrowing for a home is a necessity and borrowing for an investment can be also effective and help create wealth.
One thing to remember is that when borrowing for an investment, the tax office generally allows you to claim the interest if the investment has a goal of producing a return or income. i.e. it’s an investment purpose. Note that the tax office is not that generous, you do not receive all the interest back! The term “negative gearing” is used a lot and in my view is misunderstood as a benefit. Negative gearing basically means you make a loss on the investment, however you get to claim tax on the negative gearing or debt component. Intrinsically this does not make great sense unless the asset has growth potential.
Don’t get caught in a tax focussed investment, instead focus on an investment that has great growth potential and then consider the tax outcomes once you feel the investment is sound.
No debt is always better than any debt, but of course, when buying a house not many people have $2m lying around in the drawer!
Home tends to be an asset that you hold onto for some time, so the asset is strong and relatively secure. Holding debt against this secure asset is ok, but again only at an amount that is reasonable for your situation.
Investment debt should only be taken with a long-term view, as the asset (e.g. a property) may not increase in value every year and may even go down in value in some years. So, you want to make sure the income from rent is stable and you are buying a property that has relatively low management costs.
Borrowing to buy shares is also popular but be aware that shares are priced daily which can affect investor emotions. When the shares fall tomorrow you will need to have a documented long-term strategy to make sure you don’t panic and ensure you stick to your wealth plan.
I’ve generally found borrowing against property a better strategy for this reason. But it depends on your own situation.
While shares and property have shown historical long-term returns, the short-term return on any risk asset can be negative so when taking on debt always make sure you are comfortable with this possible downside scenario and have a long-term plan.
Do I reduce my home loan or investment loan first?
Normally home loans are not tax-deductible because you live there and don’t generate income for your home. So normally we would say that you should reduce this debt first. It’s important to get personal advice however if you require it, to make sure it’s the right strategy for you.
Do I use a broker or a bank for my loan?
Over the years the banks have moved away from retail shops and having lenders available in every branch, so it makes the market “broker friendly”. Brokers also can select from numerous banks and in theory make sure you get the best deal.
A good broker can help you navigate the application process smoothly and hopefully make the process simple and easy and of course save you money. A good broker is a relationship that makes sense in my view and should be part of your professional advisers’ network.
3 Tips for managing debt
Start repaying debt immediately
The key with debt is if you need it for a home or investment, start the next day implementing your plan to reduce that debt even if it’s $5 a week. The habit will help you get the debt down.
Always factor in rates being higher
Make sure you can afford the debt even if rates go up and I suggest keeping at least 6 months expenses in cash in a rainy-day or emergency account.
Life is a long road and you don’t need to “get rich” by tomorrow. Take one step at a time that is within your personal strategy not someone else’s.