There are plenty of allies you can make use of as you start to take control of your money. Despite what you may think, debt is actually one of them.
We should preface this by saying that you have to be careful with debt, as it can either help or hinder you, but if managed correctly, it can become your ally in growing your earnings.
Most people will use debt in their lifetime – whether it’s to buy a house or car, or even study. Debt helps us get where we want to go, which is why it’s worth taking the time to devise strategies to best utilise your debt and make it your ally to invest.
If you haven’t yet, go an have a read of our blog on the different types of debt, to get an understanding of which types of debt are best to have and best to avoid.
So how do you make debt your ally? The simple answer is cashflow. By choosing the right loan and payment option for your circumstances and goals, you can utilise debt to positively influence cashflow and help you grow your investment portfolio.
There are two standard payment options, interest only and principle and interest.
This is a loan where you pay off the interest incurred on the debt, rather than making any headway towards paying off the debt balance. The trap with interest only is that you will not actually ever pay down the debt. This is a real problem if you have high leverage (that is, if the debt on your investments is greater than 50%).
The issue can be that you will never have much equity to ensure that the cashflow from your investment is significant. Interest only can work well with instalment/savings plans. This is when you are consistently borrowing while also providing equity to an investment. You might contribute $1,000 of your own funds and borrow $500 a month. When doing this it can make sense to pay interest only, while your debt continues to grow.
Principal and interest
This is the ideal way to pay down debt as the debt balance will reduce over time. This gives you greater equity over time and ensures that your investments will provide greater free cashflow over the long term. The issue with principal and interest is that it will take some of your cashflow to pay down your debt which you could use to invest in other ways.
Which is best?
As you can see there is no right or wrong answer on how you actually address your debt, and this is why it is important to consider HOW you are investing in order to choose the right debt and repayment option. Let’s take a look at some examples of using investment debt in the right way.
Jack buys a commercial property for $500,000 with 70% leverage – that is, the bank is providing $350,000 towards the purchase price. The property pays cashflow (yield) of 7.8% ($39,000) per annum. The interest rate on the debt is 5.5%. Jack paid a deposit of $150,000 plus other costs of $30,000. The cashflow on an interest-only loan for this property would provide Jack with $19,750 per annum – more than 10% of the money Jack invested. The cashflow for a principal and interest loan over 15 years for this property provides $4,680 before tax (Jack even gets a refund due to depreciation claims). The interest provides a tax break on the investment, and taking on the debt allows Jack to access a better investment that he may not have been able to access otherwise, giving him a better return.
Jill decides on an instalment gearing/savings plan – 50% (that is, borrowing 50% of the investment amount) using a diversified growth portfolio, paying 6% gross income (including tax credits). Investing the amount of $20,000 per annum of her own money and $20,000 per annum of borrowed funds over a 20-year period, Jill has an investment of $1 million. She receives cashflow in the first year of $2,353.75 which she can choose to reinvest. Furthermore, the tax rules on this type of investment mean that Jill pays minimal to no tax over the investment period.
In order to make debt your ally, its critical to onboard the help of a professional. At PCR Accounting & Advisory, we’re experts in advising on debt reduction, debt recycling and investment strategies to help you make the most of what you’ve borrowed. Give us a call today on 03 9847 7516.
Owner of PCR Accounting & Advisory, Peter Marmara-Stewart is a top-tier accountant and financial advisor dedicated to helping clients reach their business goals and achieve financial freedom. Peter is highly regarded for his client-focused approach and entrepreneurial spirit, catering to a diverse range of professionals across a wide scope of industries all across the country. Peter’s expertise can help you plan effectively, set goals, maximise profits and protect your assets. Get in touch today on (03) 9847 7516.