Using Borrowed Funds to Invest

Friday, January 31, 2020
Using Borrowed Funds to Invest

Written by Hudson Adviser Michal Park

With interest rates at historically low levels – and arguably set to stay very low for a very long time - there has never been a better time to borrow money for investment purposes.  And with banks easing lending restrictions, it has never been cheaper to get a loan or easier to service a loan.

In addition, there has never been a better time to invest surplus funds rather than simply focusing on debt reduction.

If you have a home loan with a 3.50% interest rate, making repayments to your loan will provide you with a tax free return equal to your interest rate - so a 3.50% return.  If your marginal tax rate is 32.50%, that 3.50% saving is essentially equivalent to a 5.20% return from shares.  Given that the stockmarket has returned, on average, in excess of 9.00% per annum over the last 30 years, it’s clear that the current climate is very conducive to a better outcome for surplus funds than simply debt reduction.

If you borrow funds to invest, the residential interest rate is likely to be higher at around levels of 4.50%.  Still, to break even, you would need returns from investments to be at least 6.70% (not taking into account the tax deductibility of the interest expense).  Again, with returns from shares exceeding that quite convincingly over the long term, it is definitely a strategy worth considering.

Things to note:

  1. Borrowing via means other than using equity in your principle residence will mean you pay higher interest rates.  For example, borrowing using a margin loan will cost approximately 6.26% per annum (Commsec adviser services current variable rate).  The outcome here is that it is lineball as to whether using a margin loan to invest will provide superior returns – however, the option may be to look at a more aggressive suite of investments to try and achieve greater returns than the average.

  1. The key difference between using surplus funds for debt reduction versus investment purposes is that the former is a guaranteed rate of return, whereas the latter is not.  This means it carries more risk to invest due to volatility of returns. 

  1. Additional considerations can be seen in the table below:

Factor

Debt reduction

Investment

Returns

More advantageous to invest when mortgage interest rates are low

Compare expected return from investments with mortgage (see example above)

Tax

Is the interest rate tax deduction (ie principle place of residence of investment)?

The after tax return from investment will vary according to franking credits, overall tax position etc.

Time Horizon

If you have less than three to five years available to invest, then debt reduction is less risky

Long term investors will have a better chance of earning greater returns than simply debt reduction

Income

If employment is uncertain, debt reduction is more suitable.

If employment is stable, investment becomes less of a capital risk

Risk Profile

Debt reduction provides a guaranteed return for conservative investors

Investment will provide better long term returns for investors with a balanced to aggressive risk tolerance

Tom Stevenson, Investment director of Fidelity International believes that shares are the asset class of choice in 2020.  “The… reason to favour shares this year is that the decreasing effectiveness of monetary stimulus means that governments wishing to support their economies (all of them) will need to shift their focus to fiscal expansion. More public spending, with the likelihood of higher inflation as a consequence, is much better for shares than bonds so expect a lot of the money that has left equities for fixed income investments to head back the other way”.

Is 2020 the year you take action?

Source:

https://www.livewiremarkets.com/wires/is-a-market-correction-imminent

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