How Debt Can be Good

If you simply stand where you are and do nothing, will everything collapse? If so, you need to fix this. If not, you are a free man.

For a long time I have been uncomfortable with debt (see Why You Don’t Need Debt and The Borrower is Slave to the Lender). However, over time, I have borrowed more and more, and I think it is because I have become comfortable with debt. I used a CommSec margin loan to borrow to buy equities, which I now do not recommend to readers because interest rates on a margin loan are approximately 6 percent. I have recently started to use NAB Equity Builder, which allows borrowing to invest in ETFs or LICs for 4.3 percent which is quite low.

One of the problems with debt is that the return on investment needs to outweigh the cost of borrowing. The interest rate on the margin loan is approximately 6 per cent, which means you need to find an investment that beats 6 percent otherwise you will make a loss. However, central banks around the world are lowering interest rates and new products are emerging that allow you to gear into shares with low interest rates (e.g. NAB Equity Builder). Another argument in favour of leverage is that the interest expense is tax deductible. Currently in Australia if you are on a six figure salary, each additional dollar you earn is taxed at 37 percent, so if you are borrowing at 4.3 percent from NAB Equity Builder then after tax you are effectively borrowing at 2.7 percent. In my opinion, 2.7 percent should be easy to beat. As of right now, an ASX200 ETF such as STW is providing 5.66 percent in dividend yield, which after tax is 3.5 percent. Once you add in franking credits and capital gains, you are well ahead.

What about freedom?

One of the arguments used against debt is that debt reduces freedom because you are obligated to pay it. If you have an obligation, this reduces your freedom. However, just as in personal finance we look at both expenses and income so too when considering personal freedom we should look at both obligations to us and obligations from us. While personal finance is about cashflow and net worth, personal freedom is about obligation and specifically whether all your obligations are offset by obligations others have to you. Being free means having as little net obligation as possible.

In a previous post I discussed how freedom ultimately depends not only on cash flow but on “obligation flow.” We all have obligations e.g. the obligation to eat to survive as well as the obligation to put a roof over our head to shelter ourselves. However, if we have enough passive income e.g. from dividend ETFs to cover these costs, we are free, and we are free because our obligations to us (from the companies paying dividends to us) is greater than the obligations from us (to eat and sleep). Basically if your passive income is greater than your living expenses, you are free. It is net obligations that matter.

The same concept applies to debt. Suppose you have an obligation to pay interest. That may not be a problem if you own enough dividend ETFs to cover the cost of the interest. In the example above, the STW ETF’s dividend yield (or a similar ETF e.g. A200, VAS, or IOZ) is enough to cover the interest cost, even after (or especially after) tax.

It is important to keep in mind that dividends are strictly speaking not obligations that companies have. Technically companies do not need to pay any dividends. However, in reality, companies that have historically paid high dividends continue to pay high dividends because of shareholder expectation, and if shareholder expectation does not meet reality, share prices will go down, and the executives deciding how much of company profits to distribute as divdends are usually remunerated with shares, so it is in their interest to ensure the company is both profitable and continues to pay high dividends. Something else to consider is that dividends are not the only form of obligation. A company may use debt to raise capital from bond investors. In this case, there is a real obligation that the borrower has to pay bond investors. Furthermore, going back to shares, companies don’t need to pay dividends to provide value to shareholders. Simply retaining and reinvesting profits back into the business helps the business grow, which increases stock prices. Once the shareholder sells the stocks, there is an obligation to the shareholder to receive the proceeds of the sale. Outside Australia where there is often no franking credits, building wealth through capital gains is much more popular due to tax efficiency.

In summary, holding debt can be consistent with the idea that it is important to minimise obligation because you can have obligation from debt but have it offset with other people’s obligation to you. However, what I should emphasise is that offsetting obligations in this way increases risk. You may have debt to the bank and rely on dividends to pay back the debt, but there is no guarantee dividends will not be cut in the future, and so by playing the middleman game effectively you are taking on risk. The reason why middlemen exist in the world is because of risk transfer. Those on either side of the middleman have transferred risk to the middleman. The same concept applies at work. Middlemen are middle managers who also have obligations from them (to deliver for their manager) but need to match this with obligations to them (from their subordinates). In many areas of life, there is greater risk in aligning these two sides (obligations from you and obligations to you). The key is in if you are able to stomach and manage these risks.

Why financial capital is better than human capital

Obligation needs to be seen not just in terms of money (e.g. debt) but also non-monetary obligation needs to be considered as well e.g. something that takes away your time such as work. Most people go into debt but don’t think about what they need to do to service that debt and so they end up working for the rest of their lives. When I speak about balancing obligations from you and obligations to you, I speak mostly about your financial capital providing income (e.g. dividends) that cover your expenses. However, this ignores human capital. When banks lend you money, they not only look at your financial capital e.g. how much shares or property you have, but they also look at your human capital e.g. your income, job stability, etc.

However, relying on human capital to offset obligation is much more risky than relying on financial capital because income from human capital (i.e. a salary) is active rather than passive. If you borrow to invest and the cashflow is greater than the repayments, there is no obligation from you to do anything. However, if you borrow to invest and you have an obligation to make repayments and if your investments pay low income (e.g. it is a high growth asset) then you top up the difference with your salary which comes from human capital (e.g. your work skills). The problem with relying on human capital is that you are obligated to work in order to derive income from human capital, which reduces your freedom.

In order to take into account non-monetary obligation and to also keep a check on whether you are relying too much on human capital rather than financial capital, I recommend what I call the “do nothing” test. Basically if you do nothing e.g. don’t go to work, don’t take care of the children, etc. If you simply stand where you are and do nothing, will everything collapse? If so, you need to fix this. If not, you are a free man. Even if you have debt, if that debt is being paid for by passive income, it is as if you have no debt. Looking at non-monetary obligations e.g. childrearing, suppose you have children but they are taken care of by a childcare or nanny whose expenses are covered by passive income. You are also free. I have described the “do nothing” test in more detail in a separate post called My Changing Views:

Another key principle I feel I have not let go of is the idea that freedom depends ultimately on the absence of obligation. An obligation is something that compels you to do something in the future e.g. debt compels you to work to pay the debt. Obligation can be non-financial e.g. if you feel you must follow a particular social custom. Obligation is everywhere, and many obligations give people meaning and satisfaction in their lives e.g. obligation to their family or children. However, obligation is indeed the enemy of freedom, so if you want more freedom, you need to minimise obligation. I am a big believer in what I call the “do nothing” test, which is the idea that you are truly financially free when you can do nothing and everything is fine. If you must work to pay the bills, you are not free. There must be automated income coming into your bank account to cover all your obligations.

Can you retire with debt?

Yes, you can retire with debt, but it is harder. For one, you are no longer deriving income from human capital, so you are relying purely on financial capital to pay for debt, which is higher risk not because financial capital is riskier than human capital but because you are drawing down on one type of capital rather than two. It is much harder to get into a job than to get out of a job, so if you need a job suddenly because your financial capital is failing you, there is more effort you need to put in.

A key benefit of borrowing to invest is deducting interest expenses, which is likely to not be necessary or less necessary when you retire because your income will drop.

It all depends on how much risk you are willing to take. The good news is that it is often simple to sell down assets in order to pay off debt. Personally, when I retire, I would not want to keep debt and will simply sell assets in order to pay off debt completely.

Shares vs property

I’d like to end by discussing shares vs property. Most people think borrowing to invest is someting only property investors do. In fact, most people think stock market investors are cocaine-snorting men in suits who perform thousands of trades every day in order to capitalise on small price movements in stocks. In my opinion, shares and property are much more similar than the stereotype suggests. Shares or at least ETFs are safer investments than property because they can hold many different types of assets in them and can provide instant diversification. You can negatively gear into property and you can negatively gear into shares as well. It used to be the case that property allowed you to leverage more because you can borrow to buy property at lower interest rates than with shares (e.g. interest rates for property is around 3% or 4% but a margin loan has interest rates of 6%). However, banks are now starting to understand how similar shares and property are and new products like NAB Equity Builder allow you to borrow at 4.3% which is higher than the interest rate for most property investors (approximately 3.8% as of now) but only slightly higher. Furthermore, banks allow a property to be geared at 80% to 90% LVR whereas NAB Equity Builder allows gearing at up to 75% LVR. Even though LVR is slightly lower and interest rates are slightly higher, stock market investors are not exposed to many of the costs that property investors are exposed to e.g. stamp duty, land tax, and council rates. You also need to factor in franking credits as well as the peace of mind that comes from having a truly passive investment. For a property to be passive, you need a property manager, which eats into your rental income. Furthermore, property is not cheap. The cheapest property you can find in an Australian capital city will likely be about $400k. With ETFs, you can put in $4000 deposit to buy $15k worth of ETFs or you can scale it up. You can dollar cost average with shares but you cannot with property. You are in more control with shares, and when you sell, it can be done within days rather than months and for a much lower cost. Weighing all this up, I think shares are better than property. I would even go so far as to say that you don’t need to buy property at all, even property to live in. Rent is not dead money. If you rent and invest at the same time by leveraging into ETFs (also known as “rentvesting”) you can be better off than if you had purchased a place to live in, and you have much more flexibility to live where you want to live. But that is a post for another day.

Photo by Jamison McAndie on Unsplash

Buy a House vs Invest in ETFs

This is a common dilemma. You are saying up money and want to know if it is better to buy a house and live in it or invest in ETFs and rent (also known as rentvesting).  Personally I would invest in ETFs. The reason why is because the key difference between the two options is you pay far higher taxes when you buy a house.

For example, if you buy a house then you’re need to pay stamp duty. On a $1 million house that is roughly $57k in stamp duty, which will reduce your net worth. Assuming you save up a $200k deposit, then right after you buy your house your net worth will be $143k whereas if you simply keep your money in ETFs you’d still be at 200k.

However, an argument can be made that if you buy a house, because you have borrowed money to buy $1m worth of asset then you have leveraged exposure, which moves you up the risk-reward curve (also known as the efficient frontier). If you save $200k and invest it in ETFs, if there is a 10% increase, you have made $20k. However, if you have purchased a $1m house and it goes up 10% then you have made $200k. However, what is misleading about this comparison is that it compares apples with oranges, that is, it is comparing leveraged real estate vs unleveraged ETFs. To compare apples with apples, you need to compare leveraged real estate vs leveraged ETFs. Leverage does not increase returns without any consequences. Leverage increases risk, which may result in higher returns.

You can move up the risk-reward curve with ETFs simply by reallocating a portion of your ETFs into internally leveraged ETFs e.g. GEAR or GGUS. Another option is to invest in higher risk niche ETFs (e.g. ROBO or TECH) to move up the risk-reward curve. The benefit of buying higher risk ETFs is that there are no mandatory monthly mortgage payments or, if you take out a margin loan, margin calls. The effect of leverage is handled by the fund itself and there is no obligation for you to pay anything.

Gearing into equities is expensive before tax but cheap after tax

Another way to move up the risk-reward curve is to take out a margin loan and buy ETFs with it. The downside to taking out a margin loan is higher interest rate compared to home loans. According to Canstar, the cheapest margin loan rate is 5.20% from Westpac whereas the cheapest home loan it is 3.49% from Reduce Home Loans. However, if you buy a home to live in, the mortgage debt is not tax deductible, but the margin loan debt is tax deductible, i.e. you can negatively gear into ETFs by taking out a margin loan, which effectively lowers your interest rate by your margin tax rate. Assuming you earn between $87k and $180k and face a 37% margin tax rate then rather than pay 5.20% interest rate you are effectively paying 3.27% which is in fact lower than the home loan. If you have chosen to leverage using internally geared ETFs, because the fund manager has high bargaining power, he or she is able to get low interest rates anyway. According to the GEAR and GGUS brochure from Betashares, “the fund uses its capacity as a wholesale investor to borrow at significantly lower interest rates than those available directly to individual investors.”

Another advantage of investing shares or ETFs is that Australian shares often pay dividends with attached franking credits (e.g FDIV pays 100% franked dividends), which lowers you tax burden even further.

Capital gains tax has little impact

Even though living in a home does not make you eligible for negative gearing, you are eligible for capital gains tax exemption. However, capital gains tax is easy to avoid if you buy a hold shares or ETFs. Because capital gains tax is triggered with you sell and because capital gains tax is charged at your marginal tax rate, simply buy and hold and wait until you are retired. When you are retired, you will earn no salary, so your income will drop and your salary will likely face lower income tax, perhaps even being within the tax free threshold. You then sell off shares or ETFs bit by bit when you’re retired, ensuring that you pay little or no CGT.

Low rental yields vs high dividend yields

Now that we have established that ETFs have lower borrwing costs than real estate due to the impact of negative gearing, stamp duty avoidance, and franking credits, a huge argument for investing in ETFs rather than real estate is the huge difference between rental yields and dividend yields. As of right now, a three-bedroom unit in Brunswick East costs $1.3m and has rental yield of 1.42% i.e. around $18.5k in rent per year. However, as of right now, Commonwealth Bank shares are paying gross dividend yield of 8.6%. This means that if you have $1.3m, then rather than buying the Brunswick East unit and living in it, you can simply take out a margin loan, invest $1.3m all in CBA, and then receive $110k in dividend income per year. After income tax and franking credits, this will be around $90k. After paying rent of $18.5k you have roughly $70k per year extra simply by using ETFs.

Not only do you get $70k per year extra thanks to the extreme spread between rental and dividend yields, but the benefits for ETFs are magnified even further because of lower post-tax borrowing costs.

Using one Brunswick East unit vs one high dividend paying stock (CBA) is an extreme example. Not all stocks are the same and not all residential real estate is the same. However, the general trend is indeed that rental yields in Australia are low and dividend yields on Australian stock are high. If you bring up a list of all properties on the BrickX fractional property platform and sort by rental yield, the highest yield property, a one-bedroom unit in Enmore NSW only delivers a rental yield of 2.76% with the average rental yield about 1.5%. However, a broad ASX200 ETF such as STW provides gross dividend yield of 5%.

 

 

 

Why You Don’t Need Debt

I do have debt, but it’s a small amount. For example, I have credit cards, but I always pay it off before there is interest. I also have a margin loan, but I have this so I can buy easily when the opportunity presents itself, and I try to pay off any debt quickly.

Many people talk about how debt is a tool for making money, and theoretically this can be true. For example, if you borrow at 4% from the bank and invest in something an asset, e.g. an investment property that makes 8% then you make a profit. However, if you borrow money from the bank to invest, you need to ask yourself why the bank didn’t invest in that investment itself. The answer is that it is risky.

Banks have a certain level of risk they are willing to take. The property could have gone up 8% but there is no guarantee that it will. If there were a guarantee that the property would go up 8% then the bank would simply invest in it rather than let you borrow money to invest in it. By letting someone else borrow money to invest in the house, the bank effectively transfers risk. If the bank vets the borrower to make sure they e.g. have high enough income, etc and if there were clauses in the contract enabling the bank to seize assets in the event of default, then that 4% the bank makes is almost risk free.

But don’t you need to take on more risk to make more return?

Risk appetite is a very personal topic because everyone has different risk appetite. Generally speaking, it is recommended that young people take on more risk because they have greater ability (and time) to recover should something go wrong. This is the main principle behind the “age in bonds” rule, which states that you own your age in risk-free investments, i.e. government bonds. For example, if you are 25 you should own 25% of your wealth in government bonds.

However, if you’re a 25-year-old who has higher risk appetite, the “age in bonds” rule can be modified to e.g. (age – 25)% in bonds. This slightly more complex rule states that the 25-year-old would have zero in government bonds, which would increases to 1% when he or she is 26 and so forth.

A 25-year-old who has no government bonds and puts all his or her wealth into, say, the stock market, has a high risk appetite, but more risk can be taken if he borrows to invest.

You don’t need to borrow to take on more risk

However, even if someone does no borrow, he can still take on more risk. This can be achieved by investing in internally leveraged ETFs (e.g. GEAR and GGUS) as well as investing in more risky investments, such as emerging markets (e.g. VGE), small caps (e.g. ISO), tech stocks (e.g. TECH and ROBO), and cryptocurrency (e.g. bitcoin, ether, or litecoin).

Right now bitcoin and cryptocurrencies in general are making headlines because of spectacular growth. Had you purchased $10k worth of bitcoin in 2013, you’d be a millionaire today. However, everyone knows that bitcoin and cryptocurrencies in general are risky, and when you hear stories about people borrowing money from their homes and putting it all into cryptocurrencies, most people think this is stupid. It is not that it is stupid but rather than their risk appetite is very high.

However, the example of leveraging into cryptocurrencies shows that you don’t need to borrow in order to gain access to high risk and potentially higher returns. If you simply invest in a riskier asset class, e.g. cryptocurrencies, you already increase risk and the potential for higher returns.

Debt is slavery – the psychological benefits of having no debt

I would argue that there is no need to borrow to increase risk and return because you can simply reallocate your money to risker assets (unless you believe that leveraging into bitcoin is not enough risk).

The benefits of having no debt goes far beyond the lower risk you’re exposed to. Debt is slavery. Happiness is an elusive goal. It is almost impossible for you to know what will make you happy in the future. You may think a particular job, relationship, car, holiday, or house will make you happy, but once you actually have it, you may not be happy. Trying to predict what will make you happy is hard, which is why the best way we humans can be happy to experiment and try out different things. In order to be able to try or experiment with different things that will make us happy, we must have the freedom to do so, and you don’t have that freedom if you’re forced to work in order to pay debt.

Even though freedom does not guarantee happiness, freedom is the best assurance we have of being happy.

Freedom comes from reducing your obligations. Obligations are mostly financial obligations (debt) but can be non-financial as well.

Ultimately it depends on your risk appetite

As I mentioned earlier, everyone has a different risk appetite. I have a fairly high risk appetite myself, but there are limits. For example, I’m happy to put 5% of my net worth into cryptocurrencies. I invest in certain sector ETFs because I estimate that they will outperform in the future (e.g. I am bullish on the tech sector).

Market fluctuations can result in the value of my ETFs and shares to go down by tens of thousands of dollars and I would sleep fine at night. However, there have been many times in my life when I have gotten carried away with buying too using my margin loan account and regretting it. You know you’re taken on too much risk when you worry about it.

Results don’t matter

The outcomes from investing are probabalistic, not deterministic, so results don’t matter. This is a common investing fallacy. Some guy would claim that he is worth $100 million due to borrowing money to generate wealth and that this is proof that you must use debt in order to become rich. However, this is misleading.

The outcomes from investing are probabalistic, not deterministic.

A person may borrow money to invest and be very successful, but another person may replicate the process, borrow to invest, and lose everything. What happens for one person may not necessarily happen for another person. For example, in 2013, there were many people who stripped money from their homes using home equity lines of credit and invested all that money into bitcoin. Just about everyone called these people stupid, but now they are multimillionaires. Does this mean you should borrow to invest in bitcoin right now? No. Just because bitcoin went up from 2013 to 2017 it doesn’t mean the same thing will happen e.g. from 2018 to 2020. Investing is not deterministic. Luck plays a major role.

Do you need debt?

Suppose you put 100% of your investments into risky areas such as cryptocurrencies, frontier market ETFs, mining stocks, etc. If you feel that this is not enough risk, borrowing to invest may be the answer, but I believe that most people do not want to take on this level of risk.

Where debt may be appropriate is if you having little savings and need to borrow money to invest in something that you are fairly certain is greater than the cost of borrowing, e.g. borrowing money for education and training can in most circumstances be a good idea. Even though borrowing money will cost you in interest, you boost your job prospects and your income. If you have savings (or if your parents have savings) then it is better to use those savings to educate or train yourself, but if you don’t have this, you need to go into debt as a necessary evil.

unsplash-logoAlice Pasqual