If you were building a house, you would need to ensure it was built on good foundations to ensure its longevity. The same goes for investing. Shani Jayamanne outlines the foundations that you need to invest successfully for the long-term. This includes understanding your position with debt like mortgages and personal loans, tax, time horizon and safety buffers. 

Additional resources:

Article: A checklist for financial fitness. See if you are in a strong financial position with the right foundations.

Worksheet: Personal cashflow statement worksheet

Worksheet: Net worth worksheet 

Worksheet: Budget worksheet

Article: What you net worth statement is telling you

Article: How to assess your cash flows and create a budget

Tools: Moneysmart budget planner

Proceed to Module 3: How to set yourself up for investing success: Defining your goals

Mark LaMonica, CFA goes through the process of defining your goals. This is the first step of constructing a goals-based investment portfolio.

Back to course outline.

Module transcript

Shani Jayamanne: Finding investments that'll give you the returns you need to reach your goals is only half the journey. Structuring is crucial to ensuring that you've got the right foundations to stay on track and give yourself the best chance of reaching your goals. This module will run through what you need to consider before you invest and how to get yourself in a position that will enable you to invest confidently and for the long term.

The first consideration is ensuring that you have no personal debt or liabilities. In almost all circumstances, your priority should be debt reduction if you're in non-investment or government loan related debt. Credit cards and personal loans are the most common culprits of bad debt. It's important to understand that these products usually charge extremely high interest rates. These loans or credit cards can often snowball with the accumulated interest, so it's important to pay them off as soon as possible. The bottom line is that it's unlikely that you'll be able to earn an investment return higher than the interest rate. Most of the credit cards that you see on the market vary between 18% and 25% interest payments, so what that means is any money that you've borrowed you have to pay 18% back per year. If you borrow $1,000 you'll pay $180 just in interest payments for the year. These are significant costs.

When you invest, an 18% return in a year would be phenomenal. Over the past 140 years, stocks returned 9.2% with the worst decade of the 1930s returning an average annual return of minus 4%. If you are running the scenario, there are very few instances where you wouldn't become poorer by investing. Don't forget as well, this is worsened by taxes. You'll be taxed on any of the returns that you make on these investments. The amount returned by your investment will more likely be less than your interest payments.

So there are obviously more types of debt than a personal loan or a credit card, and one is mortgages. Should I invest while I have an outstanding balance on my mortgage? Should I just put it all in extra cash and pay it down? The main difference is that paying down your mortgage will reduce your debt, whereas investing will diversify your overall wealth and your income. This is a trade-off that many people grapple with, so we're going to spend a little bit of time going through the nuances of investing versus mortgages. It's a little less black and white than the personal loans and credit cards, and depending on a few factors, including your expected returns, your time horizon, tax situation, and how secure your income is. There are really two strategies with this, concurrent or sequential.

Concurrent is when you have a mortgage, but you're also starting to put money into other asset types like equities. Sequential is focusing your energy on paying down your mortgage and only then focusing on investing in other assets once you've paid it down. There are obviously a lot of other variables that are involved in the decision to take either of these avenues. The first is assuming that you do have extra cash after your expenses and mortgage payments. Then deciding what to do with this extra cash is dependent on a few main considerations. The first is returns. What returns are you expecting from the asset you're looking to invest in? Does it earn more on your funds than the mortgage rates?

Mortgages are a little more complicated than credit cards, while both mortgages and credit cards have interest rates that you need to beat with your investments to make it worthwhile. You have the added appreciation of housing to contend with, and that complicates the picture. But either way, let's look at market returns. ASIC MoneySmart, a government agency website, puts Australian shares at a 6.5% return over the last 10 years. This is of course historical and isn't guaranteed. Rising interest rates have historically meant lower equity returns, so this is something that investors need to keep in mind.

The second consideration is tax. Depending on the type of loan you've taken out, it'll impact your tax outcomes and deduction eligibility. If the property in question is an investment property, your interest may be tax deductible. This isn't applicable if it's your primary residence. In the same way, tax should also be a consideration if you're looking to invest in equities. All of the rates of return that we use that are used by fund managers or when you look at investment returns are pre-tax. We have marginal tax rates in Australia, so the after-tax returns from investments will vary based on how much you earn, but also the level of franking credits and capital gains you earn. So tax consequences are definitely a consideration when you're looking to invest, and you have an outstanding mortgage. Then, and this is an important one, time horizon.

This is probably the major factor that'll determine whether you employ a concurrent or a sequential strategy. As a general rule, it's said that if you have less than three years on your mortgage, it's worth focusing your efforts on paying down your mortgage. The longer you have to pay your mortgage, though, the more attractive investing becomes. Longer time horizons for equity investments have meant that they have time to compound. Compounding returns is the key to building wealth and becoming successful investors. This is when you're earning a return on your returns. The longer you have to keep your money in the market, the higher your return, meaning you have a greater chance of earning more than the mortgage interest rate. The next point is a safety buffer.

You need to ensure that you're able to afford your mortgage payments in your budget, but you also need to ensure that you have built a buffer to be ahead of your mortgage repayments before you consider investing. You never know what the future is going to hold. Wages are never a certainty. You may need to take time off work for unexpected circumstances, or you might have unexpected expenses like a car or house repair. We'll speak a little bit more about this further along in this module, but the point is that you should ensure that you have enough to cover this.

And going to that point of unexpected circumstances, one factor you should consider is how you actually earn your money. If you're in a cyclical industry, a contractor or just anyone whose income is uncertain, usually people prefer to build up a little bit of cash because of the uncertainty of a sustainable surplus in their budget, and the higher chance that they'll come to a situation where there'll be a missed mortgage repayment. This however doesn't mean that you shouldn't invest if you don't have an ironclad contract and guaranteed work. We'll walk through these buffers that you can help to build -- so you can prevent unfavorable situations where you're not able to meet your commitments. What we will say though is that investing becomes more attractive when your work is stable. The last thing you want to do is hit a period of low or no income and that'll force you to sell down your portfolio at an unfavorable time to meet your mortgage repayments.

But again, those situations are preventable with the right preparation. I think it's also important to note how paying down your mortgage impacts diversification of your portfolio. Paying down your mortgage is pure principle, meaning that you're putting more and more money into housing as an asset class. If you look at your net worth holistically, you need to decide if all your taxable wealth should be tied up in a house. And obviously your view would change depending on the housing market. But remember that there can be differences between the overall housing market and the suburb or state that your house is in.

The local economy can have an impact on housing prices in your area and preferences for where people want to live may impact the desirability of your house and the price of your particular home. Housing is generally the biggest single investment that people make. Just remember that you're adding more of your assets to this investment by paying down your mortgage. So these are all considerations for when you decide whether to take a concurrent or sequential approach to mortgages and investing. For many people owning their house is not their only financial goal. People can have goals attached to travel, a comfortable retirement, education related goals, investing for a number of goals at the same time makes sense in most situations.

We've talked about different types of debt and how to handle it. Now we'll talk about your safety buffer and that's an emergency fund. An emergency fund is a pool of savings to cover unexpected expenses. This could be medical expenses, a car breaking down or unexpected time off work. Emergency funds vary in size. Most guidance suggests three to six months of salary, but I prefer to follow a guideline of three to six months of expenses instead. And this is a personal choice and it's ultimately what works for you.

It may be more than that if you're self-employed or a contractor or you have lumpy pay. The purpose of this fund is to provide an easily accessible source of funds when you need it. It's important that you're prepared for the unexpected. Focus on building this emergency fund before you consider investing. If you have extra cash after your expenses every paycheck, which you probably do if you're considering investing or are investing, make sure that you use this cash to build your emergency fund first. Some people find it really hard to keep their hands off large sums of money like that. So a good tip is out of sight, out of mind.

Open a bank account with another provider. It's still accessible, but it's not in front of you every time you log into your banking app. I do this so I keep my emergency fund with another provider just because it's a lump sum. I've used it as an opportunity to give it to a provider that has a higher interest rate than my current bank. So I'm earning a better return on cash and it's out of sight as well. So I don't feel tempted to dip into it. Ensure as well that you're calculating your expenses properly. You may have different expenses month to month, so ensure that you look at your expenses over the space of three months or even over 12 months when you come to the amount that you decide that you want to have in your emergency fund.

Okay, so you're at the point where you've got a surplus and that's why you're looking to invest. We need to look at whether this surplus is sustainable. Budgeting is a key enabler of investing. What it allows you to do is understand your surplus, so how much you'll have left over after your expenses and that's the only way that you're able to comfortably invest without getting into situations where you'll have to overextend yourself. There are all sorts of different budgets. What works for you will really depend on you, your spending habits and your personality. If you're not sure where to start or you haven't started budgeting, you shouldn't start investing. The best place to start would be a personal cash flow statement. This is understanding where your money is going now and what you're spending it on. If you're interested in your own personal cash flow statement, you'll be able to find the template in the resources section.

Once you've understood your position, you can start to budget assigning part of your income to different expenses. Because expenses can vary month to month, make sure that you use the same rule as an emergency fund. Use several months as a guide so different expenses can be accounted for. There are a myriad of different budgets and rules we could go through, but what's important is that it works for you. Give yourself an opportunity to live your life and create a sustainable budget that you can maintain and that can create a steady stream of surpluses for your investments.