Borrowing to invest is based on the premise that it’s best to use other people’s money (OPM) to build your wealth. In this case, we’ll look at using your home as security to access the bank’s money and invest in Australian shares.
But while it sounds simple in theory, it’s important to consider both the risks and the rewards when taking on additional debt.
At Liston Newton Advisory we’re here to help you get the most out of your investments. Get in touch with one of our expert advisers today to find out how to structure your investments for success.
When to consider borrowing to invest
In Australia there are three financial conditions that make borrowing to invest an attractive option:
1. Record low interest rates on home loans
With interest rates for investment loans now dropping below 4%, money is currently cheap. Lenders have also eased up their serviceability calculations — meaning they’re not as strict in their borrower assessments.
2. High dividends for Australian companies
The second favourable condition is the high dividend-payout ratio of Australian listed companies, which have some of the highest dividends in the world (see graph below). Australian investors continue to demand high dividends from Australian companies, which means that many blue-chip Australian companies continue to pay out between 4% and 6% in income per year.
The result is that you can borrow for under 4% to buy investments that will pay out between 4% and 6%. This means you can also potentially benefit from ongoing capital growth and an increase in the price of shares over time.
3. Long-term performance and Australian share market stability
The third favourable condition is the long-term growth of the Australian share market, which has grown just under 10% per annum over the last 25 years when factoring in both income and growth in price.
Together, these three factors makes borrowing to invest worth a closer look, as shown in the scenario below.
Borrowing to invest: an example
Currently you have $300,000 owing on your home, which is valued at $1 million. You can borrow a maximum 80% of the value of your home ($800,000), minus the existing loan ($300,000). Therefore, you have $500,000 of available equity in your home.
Let’s assume you borrow another $300,000 (interest only loan) and invest this capital into an investment portfolio of Australian shares.
- The interest rate on your investment loan is 4.0%, making the interest payments on the loans $12,000 per annum.
- You invest in a growth-orientated portfolio that targets 4.5% in dividends and capital growth of 4%.
- The share portfolio would produce $13,500 of dividends per year – which pays off the interest of $12,000 per annum and leaves an additional $1,500 to invest each year.
- If the portfolio was able to achieve an average capital growth of 4% per annum over 10 years, the value of the portfolio would be estimated to grow to $460,582 at the end of year 10.
Borrowing to invest: advantages
Borrowing to invest is a great way to boost your wealth creation by putting the equity in your home to work.
For example, in a year where house prices increase by 4%, the share market should also increase by 4%. A $1,000,000 home would increase in value by $40,000, and a $300,000 share portfolio would increase by another $12,000.
The interest on the loan is tax deductible, offsetting the dividend income from the shares, and does not increase your taxable income.
Borrowing to invest can add diversification to your overall investment portfolio. Even if property prices go down, your share portfolio may not perform badly, and vice versa with the share market.
In general, interest rates and the share market are positively correlated – so when interest rates go up, the share market is likely to also rise. This offsets some of the downsides of interest rate rises. You can also choose to mitigate this risk by fixing your interest rate.
Borrowing to invest: disadvantages and risks
Borrowing to invest is not for the faint-hearted. The more you borrow the greater the risk, as you must repay the loan regardless of the performance of the investment.
Here are some of the major risks of borrowing to invest:
- Investment income risk. The income you receive from the investment may be lower than expected. For example, a company may reduce or not pay a dividend. Do you have funds set aside to cover this?
- Interest rate risk. Interest rates on the loan could rise. If they rose by 2% or 4%, could you still meet loan repayments?
- Capital risk. The value of your investment may fall and the proceeds from the sale may not cover the remaining loan balance. Do you have other funds set aside for this?