Don’t let investment goals be blinded by interest rate rises.
More than $650 million in loans were drawn down in April alone for the purpose of personal investment, and that doesn’t include financing property.
Investors have enjoyed low interest rates across the last few years, but now the cost of money is turning skywards. Indications are that the Reserve Bank are not yet finished hiking interest rates, and as lenders inevitably follow suit, the landscape will change for leveraged investors.
Rates going up should not mean hitting the panic button and ripping up investment plans, but it might mean tweaking the strategy to make sure your goals stay in view.
Start your review with remembering why you borrowed in the first place – to deliver on your unique investment objectives. Whether it’s planning for retirement or funding a project, your goals give direction and purpose to the financial plan.
Readjust your stride
Hurdles are not just for track athletes. The hurdle rate is a factor taken into consideration when borrowing for investment.
Let’s assume the cost of borrowing for investment purposes is 3%. With a salary in the top marginal income tax rate, the after-tax interest cost, or hurdle rate, is approximately 1.5%.
A borrowing to invest strategy is profitable, if the investment return exceeds the hurdle rate.
Over the last two years, the hurdle rate has been very low, around 1.5% to 2%. Most asset classes have exceeded that with ease, and therefore investors have generated a profit.
As interest rates rise, that hurdle rate will start to get higher and more challenging to get over.
It is still plausible to clear a hurdle rate that reaches 4% or 5% if you’re investing in growth assets, but an annual return below the hurdle rate will become more frequent, and the strategy can oscillate more frequently between a gain and loss position. Investors will need to be more selective about the assets they invest in and focus more on the cash flow of the gearing strategy.
A buffer is an amount added to the hurdle rate to allow for interest rate increases and unforeseen cash flow issues. It is prudent for investors to review what their cash flow would look like if interest rates increased by 1.5-2.5%. If this extra interest cost is not manageable, investors can get ahead of the curve by reducing their gearing level before their financial position becomes too tight. Equally, you can re-assess whether borrowing is required at all to achieve your objectives.
If you can achieve your objectives without borrowing to invest, you may be taking unnecessary risk by implementing a gearing strategy.
Cut down your interest bill
Many investors have multiple debts – some deductible, some non-deductible. As a rule of thumb, it makes sense to repay your non-deductible debt sooner than your deductible debt, because a tax benefit can be claimed on the deductible debt.
Consolidating debt is a common strategy for investors with multiple loans. Consider refinancing higher cost loans into your lowest cost loan to reduce your overall interest cost. Noting that it is generally not recommended to consolidate deductible and non-deductible debt.
An offset or a redraw facility is also useful for borrowers. These allow investors to offset the interest costs incurred on the loan. For investors with a debt outstanding, it does not make sense to accrue cash in a bank account, earning a lower rate of interest, while incurring a higher rate of interest on outstanding debts.
Any income, including a salary, could be directed straight into the offset account, even if it only saves a week or two weeks of interest cost on a loan. When that’s compounded over a 10- or 20-year period, it makes an enormous difference.
Consider the exit strategy
Often people get frustrated that financial institutions won’t lend them large sums against a high-value asset. In the investor’s mind, the calculations make sense – they want to borrow $1 million and they have $2 million in assets to secure it against, so why does the bank provide the financing?
The bank needs an investor to have sufficient cash flow to repay the debt because that is the primary exit for a debt. Selling the asset to repay the loan is the backup strategy, not plan A.
Use this mindset when examining a personal gearing strategy by making sure you have enough cash flow to repay the debt, plus a margin of safety. If you’ve borrowed at 3%, borrowing costs of 5% should be factored in as a buffer against interest rate rises in the future.
If you are relying on selling assets to extinguish the debt at retirement, there is considerable timing risk in trying to sell the asset at a high point. For a portfolio of assets, consider gradually selling down over an extended period to average your exit price. Or, for single-asset strategies, such as real property, be prepared to be flexible on your sale date. Being a forced seller when markets are down will be a painful experience.
There’s no doubt there are a few investors feeling edgy about what the future holds with the rising cost of borrowing and concerns about growing their wealth.
As rates go up, use it as a catalyst for reviewing the investment plan, and factoring in the additional risk that comes with borrowing to invest. Take some time out to assess your position and make sensible adjustments but don’t lose sight of your goals.