Tag: nab equity builder

Rentvesting with NAB Equity Builder

Rentvesting (a mix of renting and investing) involves renting a place to live while investing. When many people talk about rentvesting, they refer to renting and investing in property at the same time. However, another way to rentvest is to rent while investing in the stock market via ETFs.

When rentvesting into the stock market, it is better to leverage into the stock market i.e. borrow money to buy ETFs. An EY study into rentvesting into the stock market found that renting while leveraging into the ASX 200 index using a margin loan with 50% LVR was approximately equivalent to buying a place to live in. However, this study found that without leverage, it is better to buy a home. More leverage provides higher returns (and higher losses as well should the market go down).

Rather that using a margin loan, I recommend using NAB Equity Builder (NAB EB) instead because the interest rate on a NAB EB loan is much lower. As at the time of writing this, the NAB EB interest rate is 3.9 percent vs the CommSec margin loan interest rate of 5.5 percent. Many people criticise margin loans because of the dreaded “margin call” but if margin loan interest rates were equal to NAB EB interest rates, I would prefer a margin loan because it provides more flexibility on when to make repayments vs NAB EB which requires monthly repayments. A margin call is not as bad as many claim it is because it provides you with more flexibility on when you make repayments whereas regular monthly repayments do not provide as much flexibility because you are forced to pay monthly. However, this added flexibility has a cost i.e. a higher interest rate.

Another major disadvantage with NAB EB is that it is not an interest only loan and you are required to make principal repayments which are quite high considering the loan term is only 10 years. Property loans are typically for 30 years, which spreads out the principal repayments. Some property loans are also interest only. Margin loans provide the most flexibility by requiring no interest or principal repayments so long as the LVR is below a certain level. The consequence of these higher NAB EB principal payments is that the level of leverage achieved via NAB EB is lower compared to what could be achieved via a property loan or a margin loan.

An example

I have created a spreadsheet that details a typical example of someone who saves $130k deposit to buy a home and compared it to someone who instead puts that $130k into the VDHG ETF using NAB EB. After ten years, the person who uses that $130k deposit to buy a home has a net worth of $760k whereas the person who uses that $130k to leverage into VDHG has a net worth of $790k. What this shows is that by renting you are not throwing money down the drain. In fact, both option yield fairly similar net worth.

Renting and investing in VDHG via NAB Equity Builder is a good alternative to buying and living in a home

Let’s imagine you’re thinking of buying a $500k apartment, which means that you’d typically need a 20% deposit of $100k. Add in the stamp duty and it is about $130k deposit you would need in order to buy this property.

The alternative option is to put this $130k into NAB EB as a 35% deposit and buy $371k worth of VDHG. You might be wondering why the deposit amount is 35% and why VDHG is purchased. Basically you cannot achieve as much leverage with NAB EB as you can buying a property. When you buy a property, you have lower interest rates (2.69% compared to 3.90%) and you can borrow for 30 years vs NAB EB which only allows you to borrow for 10 years. The 35% deposit for NAB EB results in lower leverage (65% LVR vs 80% LVR for the property owner) but has similar cashflow. In other words, the property owner is paying $32k per year made up of $26k in mortage repayments, $5k in maintenance and $500 in council rates whereas the person renting also pays $32k per year made up of $38k in monthly debt repayments, $15k rent, -$15k in VDHG dividends (after PAYG tax), and -$5k in interest deductions.

What these numbers show is that the NAB EB disadvantage of high principal repayment is offset by the advantages that rentvesting provides i.e. you recieve dividend income and the ability to deduct interest expenses. The dividend income of $15k is after PAYG tax, which is assumed to be 37%. This dividend income covers the rent.

After ten years, the property owner sees his or her property worth $500k grow in price to about $1.06 million and has debt of $300k (calculated using a CBA mortgage calculator), which results in net worth of $760k. The renter sees his $371k of VDHG grow to $813k and has zero debt (as NAB EB loans are for 10 years). The renter has a higher net worth of $813k vs $760k for the property owner, but we need to consider the capital gains tax exemption that the property owner has, which means that the ETF owner pays $22k in CGT. The $22k in CGT takes into account the 50% CGT discount. The calculations also assume that the renter realises capital gains when he or she retires and therefore faces a lower marginal tax rate and draws down $40k per year in retirement. Because ETFs are more divisible than property, $40k per year can be sold, which reduces capital gains tax by spreading it across multiple years. After capital gains tax is considered, the renter has a net worth after 10 years of $790k vs the property owner’s $760k.

It is important to note that although renting comes out on top by a small margin, this analysis does not include measures that government often implement to entice first home buyers into the market e.g. recently there was an announcement by the Victorian government to reduce stamp duty by 50% for a limited time. These various incentives are not included in the analysis because they differ from state to state and typically do not last long. If these government incentives are included, the advantage for renters is likely to narrow or even disappear, but the main point of this analysis is that renting is not “dead money” and that you are not considerably disadvantaged by renting.

VDHG vs one property is not comparing apples to apples

One criticism of this anaysis is that the renter invests in VDHG, which is a broad and diversified high growth ETF provided by Vanguard that invests mostly in global equities whereas the property buyer buys one house. The property is not diversified and the price is estimated based on the price history of one Melbourne property on the BrickX platform (BRW01) that provided the highest returns (7.8% per year). In my opinion, this is more realistic as the property owner is buying one house to live in, and so the price history of one house should be used to estimate future returns.

However, comparing diversified stocks (VDHG) to undiversified property (BRW01) is arguably flawed. If we are to use undiversified property (BRW01) for our analysis, we have higher risk and therefore higher returns whereas the high diversification of VDHG reduces the risk and returns thereby putting the rentvester at a disadvantage. To compare apples to apples, we’d need to compare undiversified property (BRW01) to undiversified stocks, but then the question is which stock? If we choose Tesla stock then this returns 62% annualised. A renter who invests in Tesla stock undiversified would have achieved much higher returns compared to the home owner simply because his capital exposed to a very high growth asset. However, even though the renter is able to select good stocks, he or she may choose a bad stock that performs poorly. It makes sense then that we use VDHG, which diversifies across almost all stocks globally. However, we need to apply the same approach to property to compare apples to apples. If we remove the advantage of stock picking for the renter then we need to remove the advantage of property picking for the home owner. A home owner may pick a great property through research of public transport, schools, etc but the home owner may pick a bad property as well. In order to compare apples to apples, we need to diversify across all property across multiple countries. However, by doing this, the returns of property start to look very bad.

PWL Capital has considered this issue and looked at global diversified property vs global diversified shares: “To estimate this cost, we need to determine expected returns for both real estate and stocks. A good place to start is the historical data. The Credit Suisse Global Investment Returns Yearbook 2018 offers us data going back to 1900. From 1900–2017 the global real return for real estate (net of inflation) was 1.3%, while stocks returned 5.2% after inflation. If we assume 1.7% inflation, then we would be thinking about a 3% nominal return for real estate, and a 6.9% nominal return for global stocks.”

In other words, global property returns only 1.3% after inflation whereas global shares return 5.3% after inflation. This shows that the returns of property are very poor compared to shares. A property owner may argue that he is able to select good property in certain suburbs or cities, but the renter who invests in stocks could also make that argument that he is able to select stocks like Tesla, Amazon, or Afterpay.

Arguably, if you pick stocks e.g. Tesla or Afterpay (or even crypto such as bitcoin or ether), you are speculating whereas if you buy a diversified index fund such as VDHG or DHHF then you are investing. However, the same logic applies to property. If you select specific properties, which you must if you are looking for a place to live in, then you are speculating and not investing.

If you buy VDHG rather than select stocks, you reduce risk. You could have purchased APT but you also may have purchased a dud like Flight Centre (FLT). By investing in VDHG, you diversify and reduce risk. With the property you live in, there is no ability to mitigate risk. There is no VDHG equivalent for the property you live in because you are only buying one property in one location (unless you’re a billionaire who has multiple properties across multiple countries). As such, you don’t know if you will select a property in a suburb that does poorly due to e.g. zoning or if the property you buy may have existing cladding, termite or mould problems.

Once we compare apples to apples and compare diversified property to diversified shares, the renter is much better off than the buyer.

If you have higher income, consider more leverage with NAB EB

NAB allows LVR on VDHG of 75%, so leveraging with 65% LVR is well below the 75% limit. However, if a renter has high income, he or she is able to increase LVR. The table below shows ETFs where approved LVR is 80% which is the highest level of leverage. The highest LVR of 80% is allowed on global ethical ETFs (ETHI and HETH) and “old-style” Australian LICs (AFI and ARG). NAB EB also allows 80% LVR on a bond ETF (RGB) which in my opinion seems pointless.

NAB Equity Builder approved ETFs and associated LVR as of 21 November 2020 (Source: NAB website)

The age pension

One argument for owning a property you live in is that it is not considered as part of your assets in the asset test for eligibility for the Australian age pension.

However, if you own a liquid asset like ETFs then it is easy to simply sell that and buy a property in your own age if it is advantageous to do so. However, capital in the property you live in has an opportunity cost that may be greater than the pension you receive. Imagine you have a $1 million house and you get $24k pension per year from the government (which is the age pension payment for a single person as of January 2021).

Now let’s imagine instead that you put that $1 million in a high dividend ETF such as IHD and get $60k per year (IHD has a dividend yield as of January 2021 of about 6%). You’d pay income tax on this but that is offset with franking credits. You’d be able to rent that house for about $30k (rental yield is about 3% in Melbourne) and have 30k per year in spending money.

In both these cases, the home owner and renter are living in a $1 million house but the home owner gets $24k per year in age pension to live on whereas the renter is getting $30k in dividend income (after rent) to live on. The renter is slightly better off in this case.

Psychological considerations

The misconception that “rent money is dead money”comes from not perceiving opportunity cost. When you rent, there is a clear cost you are paying in the form of the rental payment made to the landlord. However, when you buy a home, there is an opportunity cost that is incurred because the capital locked up in the home could have earned a higher return. This capital could have earned an income if you don’t live in the property and instead rent it out and collect rental income, but the capital could also earn dividend income if invested in stocks. Furthermore, because there is no ability to diversify the property you live in, another cost is higher risk. Opportunity cost and risk are harder to perceive compared to cold hard rental payments.

There are also many psychological arguments home owners make in favour of home ownership which I think are valid. For example, a renter needs to move if the landlord forces him or her to do so whereas a home owner does not need to move because he or she owns the property. Furthermore, a home owner can do whatever they want to the property whereas the renter may need to ask permission before they e.g. put up solar panels. That being said, renters express control by selecting the property they want. If they want a property with solar panels, they can look for a property with solar panels and rent it. Furthermore, the renter, in selecting a property to rent, controls both the property and the neighbourhood surrounding the property. For example, if a renter lives in a neighbourhood they think has low crime, over time this neighbourhood may start to have high crime. A renter is able to move out to a better neighbourhood whereas a home owner will face $30k in real estate commissions to sell the property and another $30k in stamp duty to buy another property in a better neighbourhood. Chances are they will just stay in the neighbourhood and put up with the higher crime. This lack of control that owner occupiers have over the neighbourhood in which they live is the reason why we have the NIMBY phenomenon. The flexibility provided to renters to simply move if anything goes wrong arguably provides more control over both the property they live in and the neighbourhood in which they live, which is a psychological argument in favour of renting.

Further research

Ben Felix (PWL Capital) compares renting to buying. Note this video is geared towards Canadians rather than Australians.

Note: As of 21 November 2020, new applications for NAB Equity Builder are not being accepted due to high demand. You are able to fill in an expression of interest on their website if you’d like to be notified when applications are open.

Living off Dividends vs the Four Percent Rule – Part 2

According to Wikipedia, financial independence is defined as “the status of having enough income to pay for one’s reasonable living expenses for the rest of one’s life without having to rely on formal employment.”

Financial independence does not mean you have e.g. a late-model luxury car, an expensive house, a nice watch, or even a paid-off house. If you have to work, you’re not financially independent because you are dependent on your job.

So how do you live off your investments forever? There are two main ways to achieve this: (1) live off dividends and (2) sell assets according to the “four percent rule.”

In a post I made back in 2018 titled 4% Safe Withdrawal Rate vs Living off Dividends, I claim that it is better to live off dividends because it is easier:

 [It] is better in my opinion to simply live off your investment income (dividends, rent, interest, etc) as there is no calculation involved and no work. Everything is on autopilot. That being said when living off dividends there is a trade off between income and growth (see The Problem with HVST) and this is where I think the four percent rule can be used as a guide. If your dividend income is more than 4% of your net worth, invest more in growth assets whereas if your dividend income is less than 4% of your net worth, invest in income-producing assets.

Living off dividends is indeed simple. Suppose you have $1 million. You invest it in a high dividend ETF (e.g. IHD, SYI or VHY) and that is it. The dividends will be paid to your bank account, which you live off.

However, there are many problems with relying on dividends. Typically Australian investors have relied on blue chip Australian stocks for dividends because of favourable tax treatment (due to franking credits). The problem is that these stocks tend to be concentrated among a handful of companies and historically Australian high dividend payers have performed poorly. It makes sense that high dividend paying stocks underperform because each dollar paid out in dividends is a dollar not reinvested in the company. Because the company pays out the profit as dividends, it is not able to use that money to further grow the company. The chart below demonstrates the underperformance of high dividend paying stocks by comparing an Australian high dividend ETF (black) with the broader Australian equity market (orange). For the sake of comparison, the Nasdaq 100 is represented in blue, which is the NDQ ETF tracking an index that consists mostly of technology companies that historically pay low dividends but instead reinvest profits for growth. Major companies in NDQ are Amazon, Microsoft, Apple, Google, Facebook, etc.

High dividend ETF IHD (in black) underperforms the broader Australian stock market (represented by STW in orange) and significantly underperforms the tech-heavy Nasdaq 100 index (represented by NDQ in blue). Source: Bloomberg

In contrast to the simplicity of dividends, implementing the four percent rule is more difficult, but there is considerable evidence that this approach is better, not only due to it being more tax efficient but also because the assets you invest in tend to earn more (as demonstrated in the above chart comparing the Nasdaq 100 ETF vs an Australian high dividend index ETF). Suppose you have $1 million. Rather than invest this in high dividend stocks or ETFs, you invest it in high growth stocks or ETFs that focus more on capital gains rather than dividends. You can choose NDQ, a Nasdaq 100 ETF, but if you want more diversification across countries and sectors, a good high growth ETF is VDHG, which invests in 90% global equities and 10% bonds. (Another ETF similar to VDHG but with slightly lower fees is DHHF.)

How to implement the 4% rule

When you retire, rather than rely on dividends, you simply sell off 4% of the value of the investments each year, so if you have $1 million you sell off $40k and then live off that for the first year. The expectation is that after you sell $40k then you will have $960k, but if we assume 7% annual growth then the next year your net worth will grow to $1.027 million and then you withdraw 4% of this, which is $41,088. This higher withdrawal in the next year accounts for inflation. (Note there is some uncertainty about whether, in this example of retiring with $1 million, you simply withdraw $40k each year or if you withdraw 4% of the new balance each year. I believe the latter option is safer because it explicitly accounts for inflation.)

The “four percent rule” is controversial with many arguing that it is only designed to last you thirty years. However, a simple fix to this problem is to withdraw 3% of your portfolio each year rather than 4% and, in my opinion, anything below 3% is far too conservative. Based on FireCalc.com, although the 4% rule fails with 95% probability after 30 years, the 3% rule is highly likely to last you forever. Basically if you are retiring in your 60s or 70s, you should be able to get away with the 4% rule, but if you retire any earlier, you should use the 3% rule instead.

The chart below made using FireCalc.com provides a simulation of historic stock market returns using the 4% rule and shows that over 70 years there is a good change you will not run out of money after 70 years but there is approximately a 10% probaility that you will (represented by lines going down below the horizontal red line).

Simulation showing the 4% withdrawal rate has an approximately 10% probability of failure over 70 years. Source: FireCalc.com

However, using the 3% rule, there are no probability where you lose your money (based on historic stock market performance), even under the assumption that you retire in your 30s and live for 70 years.

Simulation showing a 3% withdrawl rate being highly likely to last you forever. Source: FireCalc.com

The reason why selling off assets is more tax efficient is because capital gains are not realised until you sell the assets, which means you can sell them when you retire. By selling off assets when you retire, you do so when your income is low, which exposes more of your capital gains to low (or zero) income tax brackets. However, dividends are taxed once they are paid, which means that while you are working and accumulating assets, you’ll pay taxes on dividend income while your income is relatively high.

Capital gains are subject to Australian income tax rates once the capital gains are realised.

What will I do?

Early in my journey towards financial independence, I focused mainly on accumulating high dividend ETFs e.g. IHD and even HVST (see The Problem with HVST). When investing in purely Australian equities, I discovered that not only did my investments underperform but I also needed to pay taxes every year. To address this problem, I used a margin loan to borrow against my ETFs and diversify into international and emerging market equities more (e.g. I made some good bets on technology ETFs). Having a margin loan has its pros and cons, but one of the pros is that the interest on the margin loan is tax deductible, which helps to offset the tax paid on the dividends from Australian equities. Today Australian equities make up approximately half of my equities with the other half in international equities and a small amount of emerging market equities. Although I have a margin loan, I have started dabbling in NAB Equity Builder. NAB EB allows you to borrow at a lower rate compared to a margin loan.

While I am moving towards growth rather than dividends, I am still holding onto my high dividend ETFs. My plan is, rather than choose between dividends or growth, I will simply aim for both. There are many benefits of dividend investing e.g. franking credits. Furhermore, even though Australian high dividend stocks have underperformed in the last decade, there may be hope in the future as these companies enter the post-COVID future. If I sell Australian dividend stocks and use the proceeds to purchase global tech stocks, there is a very real risk that I will sell low and buy high, so rather than sell, I prefer to simply leave my Australian dividend stocks and ETFs. It should also be noted that there are other ETFs on the ASX that pay high dividends but do not invest in Australian equities e.g. UMAX uses options against the S&P500 to generate income; EBND invests in emerging market bonds and pays approximately 5% monthly; and TECH focuses on global tech stocks that have strong moats, and surprisingly this ETF has a dividend yield of approximately 9% paid yearly. I will discuss these non-Australian high-yield ETFs in a separate future blog post.

Property vs shares

Although it is clear that I have a bias towards shares over property, the strategy of selling down high growth ETFs exposes yet another benefit of shares vs property, which is the ability of ETFs to be sold in small chunks. If you have a $1 million property, you cannot sell half of it because no one will want half a property. You must sell it all in one go. Suppose you make $500k capital gains. Then $18200 of that will be exempt from tax while the rest of it is subject to tax, so you’ve managed to avoid tax on $18200. Now suppose you have $1 million in ETFs, which we will assume is $1 million all in VDHG. Rather then being forced to sell all of it in one go, you sell half of it in one year and the other half the next year. By doing this you realise $250k in each year. This exposes $36400 to the tax free threshold. By being able to sell smaller portions, you make the most of the tax free threshold.

Thanks to ETFs being highly divisible, I can sell off small amounts of ETFs each year thereby spreading capital gains across multiple years and exposing more capital gains to low tax brackets. Furthermore, any capital gains on assets held over one year receive a 50% CGT discount.

Another benefit of investing in ETFs rather than property is that you can sell ETFs cheaply e.g. selling one property will cost you about $20k to $30k in real estate agent commissions, but with ETFs you will pay about $20 or $30 to sell (or even $9.50 for discount online broker SelfWealth).

Other benefits of ETFs vs property is you avoid stamp duty and land tax. You also have access to franking credits.

Of course, in all fairness, there are some downsides of ETFs vs property e.g. the interest rate on NAB EB and margin loans are higher than those on mortgages, and although you can achieve leverage of about 70% using NAB EB or margin loans, you are able to achieve leverage of 80% up to 95% with property. In my opinion, even if you are able to achieve more leverage against property, it doesn’t necessarily mean you should. Leverage can magnify gains but also magnifies losses should the market go through a downturn. When leveraging into ETFs, you are able to diversify within the portfolio defensive assets such as bond ETFs (e.g. VDCO), hybrid ETFs (e.g. HBRD) or even gold mining ETFs (e.g. GDX), which reduces volatility. When you leverage into a property, you are all in one property in one place, exposed to an universified asset in one location. Many believe that property is safe compared to the volatility of the stock market, but if you invest in a highly diversified ETF, it is safer than investing in one property. The lack of volatility in property is actually the result of poor price discovery mechanisms rather than because property is inherently safer than shares. Once property is listed and exposed to the same price discovery mechanism of shares, property is highly volatile as evidenced by the price charts of residential REITs.

Disclosure: I own IHD, SYI, HVST, NDQ, UMAX, EBND, TECH, HBRD, and GDX.

More Thoughts on Remote Working during the COVID-19 Crisis

It has been a few months since the COVID-19 crisis has hit, and as a result of this crisis, I have settled into working from home. I’d like to describe my experience working from home from my parents’ home for the last few months.

Disadvantages of remote work

First of all, I find I have been quite busy. I would often either wake up early or work into the night in order to get work done. It seems there is more work to do when working from home. There are definitely advantages of working from home, but there are definitely disadvantages, the main disadvantage being that it is more difficult to work with others. For example, when you’re in an office, you can walk to someone’s desk and talk to them about something, but in a remote environment, you need to e-mail or call them, and they may not respond to your e-mails or calls. Furthermore, when I am in the office, I can walk to someone’s desk. If they are on the phone, it is clear they are busy, so I can walk away and come back at another time. However, when working remotely, I am more reluctant to ring someone because I have no idea what they are doing. They might be in the toilet or they might be changing their baby’s nappies, so there is this fear that I may intrude on their private lives whereas at work the expectation is that you work at work so you have no private life at work. Working from home does not seem to work well for “fast-paced” work where quick communication is necessary, especially when there is a deadline looming.

Advantages of remote work

There are advantages of remote work. In my opinion, there are more advantages than disadvantages. If I had to choose between working at home or working at the office, I’d prefer working at home, but ideally I’d prefer to have both options. There are some tasks I’d prefer to ask colleagues to come into the office to do, and there is also better socialisation in the office. For those who do live by themselves or who do not have too many friends outside of work, the office becomes the source of friend and family.

For me, the key benefit of working from home is I save a considerable amount of time not commuting. You don’t need to drive or take a train to work, which benefits me greatly because it takes one hour for me to get to work, which means I get two extra hours per day to sleep, exercise, read or watch Netflix. Another benefit is that you don’t need to worry about what you wear. When you go into the office, you need to dress correctly. However, when you work from home, you can wear anything. You can just put on sweatpants and a hoodie or you can stay in your pajamas. Even if you are on a Zoom call, you can turn off the video or you can position the camera so your clothes are off the screen.

Another benefit of working from home is that you don’t need to concentrate in meetings. This might sounds bad, but there are many meetings where you can safely turn off video and audio and do your other work. You can dedicate half your attention listening to the meeting (in case you need to speak) and the other half doing your other work.

Something I have noticed ever since working from home is that I am signing up to many webinars. Back in the office there are plenty of optional training sessions that I do not sign up for because I simply don’t have time. If I needed to get off my desk to go to one hour of training, that is one hour I would not be working. I only go to those training sessions that are mandatory. However, since all these training sessions are now online, they are quick and easy to sign up for, you can listen to them while doing your other work, and if something urgent comes up at work, you can simply and easily leave the webinar without any embarrassment or shame. As a result, I have gone to many webinars and feel I have learned a considerable amount about many different topics, from HR all the way to finance, retirement planning, etc.

Another benefit of the COVID-19 crisis is the amount of money I have saved. I don’t drive much, but in the last three months I have not driven at all, so I have saved a lot of money on petrol. Even when I have the option to drive short distances, I prefer to walk instead because I spend so much time indoors that I want to walk more to be outdoors. (When you drive, you are indoors.) I also never eat out, go to cafes, etc. Any socialising needs to be online, so it is free. I watch Netflix rather than go to the cinemas. Basically everything is done at home or online, which is much cheaper than “going out.”

I am still working from home and I have no idea when I will be going back to the office. I have heard that many organisations have asked their workers to come back whereas others are providing staff with the option to work from home or not. In my opinion, the best approach is to permanently give staff freedom to work from home or come into the office, which is what Twitter has done.

Impact on the property market

The impact of COVID-19 on the property market is very unclear. There is a considerable amount of stimulus being applied to prop up not just the property market but also the stock market. That being said, if remote working becomes the norm, there is no advantage of working near the city anymore. This means I can live in the outer suburbs without worrying. Even if it takes me two hours to commute into the city, if I do so rarely, it’s not a problem. This means the cost of putting a roof over your head goes down considerably. It costs about $1600 per month to rent a one-bedroom apartment in the city, but in the outskirts of the city it costs about $1000 per month, so automatically you save $600 per month. Using the 4% rule, this means you only need to save $300k to pay rent forever (rather than $480k).

The frugal non-consumerist post-COVID lifestyle

Based on quick calculations for a single childfree person living in an Australian city, COVID-19 has reduced the cost of living by about one-third, from $3500 per month to about $2111 per month. Once again, using the 4% rule, this means you only need about $633k to retire rather than $1 million.

How is this possible? Because you no longer need to live near work, you can minimise costs by moving to the outskirts of the city, which should halve your rent. I am assuming the cost of a one-bedroom apartment in Melbourne CBD vs a one-bedroom unit in the outskirts of Melbourne (e.g. Frankston). Because you are not going out at all but eating at home all the time, this should halve your food costs. You also don’t need a car because you can walk, bike or take public transport everywhere. Assuming all other expenses stay the same, this cuts costs by about one-third.

Expense ItemMonthly Post-COVID CostMonthly Pre-COVID Cost
Rent$1000 $2000
Food$311 $600
Car–$100
Other$800 $800
Total$2111 $3500
Estimated monthly cost of living pre-COVID and post-COVID. “Other” includes electricity, internet, streaming services, etc.

In my opinion, one of the benefits of the COVID crisis is that it has forced people to live a non-consumerist lifestyle, which may result in many people realising that they are able to retire early if they want to. You don’t necessarily need $1 million to retire because living in isolation has taught you that you only need about $650k to retire.

In my opinion, a post-COVID lifestyle presents an opportunity to live more environmentally sustainably. A lifestyle with less car use, less overseas travel, less “going out” and more bike riding, walking, having meetings online, etc are better for the environment. I also think that caring for the environment can help you save more money because it provides extra motivation. For example, I am driving less today not only because I save money driving less but also because I am starting to feel very guilty driving a car. This extra guilt helps to discourage me from driving or travelling or going out to restaurants.

What about the economy and personal finances?

There is a considerable amount of uncertainty about the future of the economy. Some believe there will be a V-shaped recovery whereas others are expecting a W-shape or even an L-shape. Regardless of what letter of the alphabet the stock market resembles, I am not too concerned because I have diversified my portfolio to include not just equities but also bonds, gold and even cryptocurrency.

Another benefit of the COVID crisis is that interest rates have fallen. The interest rates on my CommSec margin loan as well as NAB Equity Builder have both fallen (5.6% and 3.9% respectively). As I have explained in other posts, debt can be positive because you are able to deduct interest expenses. Many people invest with debt when buying a property, and they deduct interest expenses. It is possible to do the same with ETFs, but in my opinion the main benefit of holding debt to buy shares rather than property is that stocks or ETFs can quickly and cheaply be sold to extinguish the debt whereas a property is very expensive to sell. For example, if I borrowed money to buy ETFs and suddenly wanted to retire early, I can sell ETFs and with the proceeds I can pay off all my debt. However, if I borrowed to buy a property and suddenly wanted to retire, selling a property to extinguish the debt would cost me about $30k in real estate agent commission.

Another benefit of ETFs vs property is that you can avoid or minimise capital gains tax. If you own an investment property with debt on it and you suddenly retire, you need to sell it to pay off the debt. Selling it will trigger capital gains tax. For example, suppose you buy a property for $500k and it increases in price to $1 million. Then you sell it but need to pay CGT on the $500k price rise. However, the benefit of ETFs is that you don’t have to sell all ETFs at once. Suppose you purchase $500k in ETFs and it rises to $1 million in price. Rather than sell all the ETFs, you only sell half thereby realising only $250k in capital gains. Then you sell the other half the next year thereby maximising the amount of capital gains subject to lower income tax rates. This works in Australia because capital gains tax is based on the progressive income tax rates. Under the Australian income tax system, income (including triggered capital gains) under $18200 in the financial year is exempt from any tax whereas any amount above that is subject to tax. So if you sell a property and realise $500k capital gains, then only $18.2k of that is exempt from tax with the rest being subject to tax. But if you sell half your ETFs in one year and the other half the next year, then $36.4k is exempt from tax. ETFs are highly divisible, which allows this, but property is not. You cannot sell half the house and then the other half the next year.

Because I have invested in a range of different ETFs, if I needed to retire quickly and needed to extinguish the debt, I would simply sell an ETF that has made large gains and then offset these gains by selling off a different ETF that has made losses. The losses and the gains would roughly cancel each other out, which means there is little capital gains tax to pay. Any existing capital gains can be left untriggered. ETFs allow you to control your capital gains and therefore your capital gains tax.

Some people say that an easy way to avoid CGT is to put your money into your principal property of residence (PPOR), which is exempt from CGT. However, this does not work. When people buy an property, there is a reason why investors prefer to put a tenant into it even if doing so removes CGT exemption. It is because putting a tenant into a property provides the landlord with rental income as well as the ability to deduct expenses. The gains from the rental income and interest deductions is greater than the loss of CGT exemption. If this were not the case, there would be no investment properties because landlord would put any extra money into their main residence rather than invest it in a rental property. This means it would be impossible to rent because no landlord would put money into rental properties because the tax advantages would be greater for main residence. The government must provide rental property investors greater tax benefits for rental property compared to main residences otherwise the rental market would not exist. That rental income and tax deduction on expenses from owning investments is greater than CGT exemption on a PPOR is the key factor that justifies “rentvesting” but that is a topic for a separate future post.

Am I close to retirement?

There are two main reasons why I would feel uncomfortable retiring today. One is that I have quite a bit of debt. Of course, I can sell assets to pay off the debt, and some of my investment income can be used to meet the debt repayments. However, I feel reluctant to do this. Part of me feels that I should pay off more debt or at least generate more dividend income to meet all debt obligations.

Another reason why I am reluctant to retire is because a substantial amount of my personal wealth is in my superannuation fund, which I don’t have access to until I am 60. This means that if I retire now, I will need to implement the “two bucket system” and run down my non-super bucket that will tide me over until I have access to my super, which will help me pay off my debts. If I implement the “two bucket system” right now, I’d be living a very frugal lifestyle with a pre-super safe withdrawal rate of about 2 per cent rather than 4 per cent. I want to build up more wealth in my non-super bucket that will tide me over until 60.

New podcasts and website

While under lockdown, I have been listening to many podcasts. A recent podcast that I highly recommend is FIRE and Chill which discusses personal finance in Australia.

Another website that I find useful is the Nomadlist FIRE calculator, which helps you determine which countries you are able to retire in based on your net worth. The most expensive city to live in is New York, so if you have enough net worth to be able to retire in New York (about US$1.1 million), in my opinion you are effectively financially independent. However, what this site teaches you is that even if you have low net worth, there are many countries all around the world where the cost of living is low, which means you will be able to retire very quickly. Many people assume that they need to live in expensive cities e.g. Sydney, Melbourne, New York, London, etc. However, the world is enormous and there are so many places where it is cheap to live. For example, in Liverpool, UK you can live off US$500k. In Davao, Phillipines you can live off US$250k. Looking at sites like this is a strong motivator because as my net worth grows, I am able to tick off cities around the world where I am able to live. The ultimate achievement is ticking off on New York because then you’d have the safety and security of knowing you can retire early in the world’s most expensive city.

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