Debt recycling

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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Mark LaMonica: Okay.So today we're going to talk about debt recycling, Shani.

Jayamanne: Riveting.

LaMonica: But before, well, we're going to try to make it riveting.

Jayamanne: Okay.

LaMonica: That's the goal. Before we get to that, you were on another podcast. You cheated on Investing Compass.

Jayamanne: I did, yeah. Sorry.

LaMonica: So you were on a podcast by the Women's Agenda.

Jayamanne: That's it.

LaMonica: Which sounds very intimidating.

Jayamanne: Yeah.

LaMonica: Do you want to tell me what the Women's Agenda is?

Jayamanne: Yeah. It's a news publication. So they have a newsletter and they have a website and they publish news.

LaMonica: Yeah. And tell me about -- well, I listened to it. So don't tell me. Tell the people listening about the podcast.

Jayamanne: It was just a little bit about my story, how I got to the job that I'm in now, and...

LaMonica: We're all trying to figure that out.

Jayamanne: And why I'm passionate about the work that I do.

LaMonica: Yeah. It was great. Like, it made me very proud to work with you.

Jayamanne: That's very nice.

LaMonica: And work at Morningstar. So it was, yeah, it was really great. I shared it on my LinkedIn page.

Jayamanne: Yeah. So if you want to listen to it, it's on Mark's LinkedIn page.

LaMonica: Yeah. I have like four LinkedIn friends. So really why...

Jayamanne: Maybe connect with him while you're there.

LaMonica: Yeah. I'm very lonely on LinkedIn. All right. So as I said, we're going to talk about debt recycling today.

Jayamanne: And that does mean we're in for a bit of a wild ride, you're talking about debt and real estate, two of your favorite topics.

LaMonica: Yeah. No, exactly. But not only are we going to talk about debt, we're going to talk about getting into more debt to try to grow your net worth.

Jayamanne: So I think it's safe to say that you're just going to end up saying that debt recycling is a bad strategy.

LaMonica: I'm not, Shani. So one of the things we try to do on this podcast, if you remember, maybe you're confused because of all the podcasts you're on. But on this podcast, what we try to get across is that every investor should come up with the right approach that works for them. And that may be debt recycling. But we also want to make sure that everyone is informed when they make these decisions. And they think about the long-term implications of these decisions. But maybe before we get started, we should just define debt recycling. So why don't you do that for us, Shani?

Jayamanne: All right. So debt recycling is taking equity out of your home by borrowing and investing it. In most cases, the borrowing is used to fund the purchase of an investment property. In some cases that we have heard about, it's used to invest in the share market, although it is safe to say that that is much rarer.

LaMonica: The first thing you need before considering this strategy is some equity built up in your home. So that can be from paying back principal when you pay your mortgage. And it can be from appreciation in the value of your home. In many cases, if you've owned a property in Australia for a while, you have built up equity from both.

Jayamanne: And as we said, there are two different approaches you can take with the money you've borrowed against your home. The first and most common one is to buy an investment property. The borrowed money against your primary residence would be used to fund the down payment. And then another mortgage would be taken out on the investment property.

LaMonica: The less common approach would be just to take that money you've borrowed and invest it in the share market. In theory, leverage could be employed with the share market investment by getting a margin loan or buying a leveraged investment. But this is probably fairly rare as well.

Jayamanne: So let's start with the basics here. What are the day-to-day implications on someone's finances if they decide to proceed this strategy?

LaMonica: Well, the first thing is that it negatively impacts cash flow. You are borrowing more money and you will add to your mortgage payment on your primary residence. That will make your mortgage payment go up. If you use the proceeds to buy an investment property that is negatively geared or costs more to maintain and pay off the mortgage on that property than what you're making, then again, that negatively impacts your cash flow. And I'm a firm believer that most people are focused on the wrong thing with their finances. There's this obsession with doing everything possible to increase net worth at the expense of cash flow. And that adds personal financial risk, reduces financial freedom, and leaves less money every month to spend on things that make us happy. So we end up more stressed about money and less happy, which just doesn't seem like a great outcome.

Jayamanne: Okay. So I'm going to play devil's advocate here. But first, it's worth explaining how it increases your financial risk, reduces financial freedom, and leaves less money every month to spend on the things that make you happy.

LaMonica: Okay, well, all of those things stem from taking on more debt. So let's say you own your home. And for the sake of an example, you spend $2,000 a month paying for your mortgage. That $2,000 serves a vital purpose. It pays for the roof over your head. And you do need a place to live. If you didn't spend that money, you would have to spend some amount of money on rent. Could be more or it could be less. But the point is that you need a place to live. Then there are other needs you need to feed yourself, you need health care, and you may need to pay for transport to get to your job and for other needs, whatever is left from your income pays for your wants. These are things that make you happy. That could be a nicer car than what is needed for transport could be material goods that make you happy, or could be money you spend on experiences, maybe going out to dinner or travel, for example, we simplistically divide up cash flow that comes in between these two broad buckets, absolute necessity, and things that make you happy, we can get a picture of your finances. If you lost your income, like if you lost your job, for example, you would still have to cover your needs, but you could sacrifice your wants.

So in my head, the way to maximize happiness is to increase the amount you spend on happiness in comparison to the amount you spend on needs. Any debt you take on is an obligation into the future. Yes, you could take out debt to pay for things that make you happy, but paying it off in the future reduces the amount you have to spend on your wants, the things that make you happy again. So you're borrowing against your future happiness. And yes, you could take out debt to increase your net worth, which is the point behind debt recycling. And the hopes are that in the future, you can sell off these assets and buy something.

Jayamanne: I'll let you take a breath for a second here to play devil's advocate. The counter argument would be that any investments you make are designed to sacrifice today in order to get more in the future. We try and earn returns that exceed inflation so that we can buy more happiness in the future. And that includes being able to retire if that makes you happy and having money to pay for both wants and needs. So how does this fit into your argument?

LaMonica: Yeah, I mean, I agree with you, Shani. So all saving and investing is sacrificing today for a better future. If I save $1,000 each month, that is $1,000 I'm not spending. But the point is that debt is an obligation. Saving is not. So if I lose my job, I could stop saving that $1,000. But you can't stop the debt obligations that you have in the future. Even if you can work out a program with the bank where you delay mortgage payments or just pay interest, you're only increasing the obligations you have in the future. That is why it is increasing the financial risk you have. It also decreases the choice you have. The obligation can prevent you from taking a lower paying job if it aligns more with your passions, or if it's a better long term opportunity. It can prevent you from taking a career break, to spend more time with your children or to care for an elderly relative. It decreases the options you have. And having options is freedom. So in my mind, you are reducing your freedom by doing this.

Jayamanne: Well, another argument is that you are taking dead equity and putting it to use. That just means equity you've built up in your home that is doing nothing and using it to try and increase your net worth.

LaMonica: All right. So this is not the first time I've heard this argument, Shani. People tell me that equity is dead when it's just sitting in their homes. But it actually isn't dead. So it appreciates at the rate that your house appreciates. So we need to think about what this argument is really calling for. It is saying that not using leverage in any investment means that money is dead. If you own an ASX 200 ETF and you don't borrow money to juice those returns, it is dead equity because it would only appreciate the rate of the ASX 200. If you truly believe the money is dead, then it doesn't make any sense to take out a loan that is not interest only, whether that's on your primary residence or an investment property, because paying back principal is dead money.

At the core of this argument is the fact that residential or at least the view that residential real estate only goes up. And maybe that will be true in the future, but maybe it won't. Taking on more debt increases your returns, but it also magnifies your risk because you have more debt. So if you lose your job, if housing prices don't keep going up or if interest rates go up too much, you're putting your financial future at risk. And that is fine for some people who can afford it. For some people that are stretching too much, it can be a real problem. And for those people that overextend themselves to use their equity to keep buying properties, they will have almost all of their cash flows going to support these properties, which doesn't leave a lot left over to save and invest or spend on things that make you happy.

Jayamanne: Maybe it's worth giving an example about how leverage increases returns. Let's say that you invest $200,000 and borrow $800,000 to put into an investment. And for the sake of this argument, it really doesn't matter what this is invested in, a house, shares anything. The point is that you own a $1 million asset, but you've borrowed 80% of that asset. If that asset goes up in value 10%, you don't get a 10% return. The return on the amount of money that you put in is really 50%. You've invested $200,000 and had the asset appreciate by 10% or $100,000. Of course, you would have to deduct from that return any costs associated with borrowing that money. Primarily interest, any other cost to maintain that asset, any transaction costs, and any taxes. But the point is that the return is amplified.

LaMonica: Now, the important thing to remember is that the same thing happens if the asset goes down in value. Same scenario, but instead of appreciating by 10%, the asset loses 10% of its value. In that case, your return is not negative 10%, it is negative 50%. Once again, before interest costs to maintain that asset, any transaction costs and taxes are taken away. That is why we say that you are amplifying the return, but also amplifying the risk.

Jayamanne: Well, there's also this notion of good debt and bad debt. It's argued that good debt is debt that's tax deductible. And when you buy an investment property, you can deduct any interest payments that are made, any expense incurred, and depreciation.

LaMonica: Yeah, and I certainly get that. And that's one definition of good debt versus bad debt. So some people say good debt is anything that funds an asset as well. But I've certainly heard that argument that Shani just made associated with negative or with debt recycling. So that is true for some people and it does make sense. Just be careful how far you stretch yourself and think about what you are doing. Personally, I see investing as a means to an end. My goal is to increase my cash flow and the amount of my cash flow that goes to discretionary spending, which is the spending on things I want. That to me is financial success and increases in my net worth are secondary concern. And I know this sounds like a ridiculous argument, but it's just how I want to live my life and how I want to use my assets to try to increase my own happiness. Therefore, I want my assets to generate positive cash flows like dividends or rent on an investment property that exceeds the expenses on that property.

Jayamanne: And I would add another thing as well as somebody that recently bought a home. This is obviously a long way off for me as a new home buyer, but there is a huge financial gain from paying off your home. I know personally, my mortgage is a big part of my monthly expenditures and having that go away would add a lot of flexibility and would dramatically reduce the amount of retirement savings I need to support my life. If we go back to Mark's original example of someone who's paying $2,000 a month for a mortgage that would require a sum of $600,000 at a 4% withdrawal rate to cover that annual mortgage payment, the more equity that is taken out of a home the longer it takes to pay it off. And yes, you could sell an appreciated investment property in the future to pay off your home, but there are high transaction costs and capital gains taxes that will have to be paid.

LaMonica: Yeah, and I certainly agree with that, Shani. I would love to own a home outright. It just makes such a difference financially.

Jayamanne: One last point to consider is what happens if you borrow equity from your home and invest that equity? As we said, this doesn't happen as much, but we have both heard from people that have done it. How should people think about it?

LaMonica: Well, the first thing I would say is that one benefit to that approach is diversification. Many people have most of their net worth tied up in their homes. To take some of that equity and invest it will add diversification in case Aussie housing prices either don't appreciate or don't appreciate that much in the future. And from a diversification standpoint, it does have benefits. The problem, of course, is that as we said, there are tax benefits from a negatively geared investment property. You don't get any of those by investing in the share market. And the same considerations apply around cash flows. Those have to be covered. You're opening yourself up to interest rate risk as well. All things being equal, if interest rates went up significantly, your mortgage payment would go up. And that would put more pressure on your cash flow. And many times when interest rates go up, equity markets fall.

Jayamanne: This leads to an interesting point that I also hear a lot. I hear people say that to make an investment worthwhile, you just need to earn a return higher than the interest rate you're borrowing at. And that isn't true in the real world. It's actually quite different because of taxes, both tax advantages from negative gearing, if you are buying an investment property, and the taxes that you would own on capital gains from an investment property and from shares. Transaction costs also matter, which can be quite high if you buy a home, but also need to be accounted for with shares as well as any fees that you're paying. What return is needed is very personal. It has to do with your marginal tax rates. If the money is invested inside or outside of super and future interest rates.

LaMonica: And more than anything, we would recommend that under your particular tax circumstances and under a variety of interest rates scenarios, you know exactly what return is needed to make this worthwhile. Spend the time to figure that out before even considering debt recycling. That obviously doesn't change the outcome, but at least you're going to go in informed when you're making that decision.

Jayamanne: Mark has expressed his point of view about debt in this episode. But the larger point is that all of us need goals and an underlying philosophy on how we're going to use our financial resources, both the cash flow we receive from our jobs and from investments and the financial assets that we have to create the life that we want. There is no one size fits all. We need to be careful when we listen to any financial guidance we receive to make sure it aligns with what is best for us. Perhaps that is debt recycling and perhaps it isn't. No article or podcast can give you the answer. But no matter what choice you make, it is important that you are informed. Do your homework and understand the implications on your finances and your life if a variety of different return, tax and interest rate scenarios occur. Think about how to increase the happiness in your life and how your financial assets can help get you there. And think about how these decisions will impact your well-being because financial stress is one thing that is almost universally bad for all of us.

LaMonica: Well, I really couldn't say it any better than that, Shani. So thank you guys very much for listening. I thought that was a balanced episode on debt recycling. Maybe a couple of rants as you would describe them.

Jayamanne: There was a few times there where I could just step away from the mic and go for a walk and come back and you'd still be going.

LaMonica: Well, go for a walk, go record another podcast. But anyway, thank you guys very much for listening. And if anyone does want a copy of Shani's podcast, it is incredible. And you can email me at mark.LaMonica1@morningstar.com, which is in the show notes.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)