Borrowing capacity is usually an investor’s scarcest resource. Because it’s limited, it should be allocated with great care and consideration. The goal is to ensure every dollar of borrowing capacity is put to its highest and best use. One way to measure this, is by considering the return on borrowing capacity – a simple framework for assessing how effectively this scarce asset is being deployed
Using borrowings to build wealth
Borrowing to invest can be a powerful strategy because it allows you to put money to work today that you don’t yet have. For instance, instead of investing $10,000 a year for the next decade, you could borrow $100,000 now, invest it, and repay the loan over 10 years. If your investment returns exceed your borrowing costs, you will come out ahead.
In fact, borrowing can still be effective even if you never plan to repay the debt. This is particularly true when most of your returns come from capital growth. Capital growth compounds each year without triggering immediate tax liabilities, allowing wealth to benefit from compounding returns. At the same time, inflation steadily erodes the real value of debt – a $1 million loan today will be equitant to less than $450,000 in 30 years’ time.
Why is borrowing capacity one of your scarcest resource?
Everyone has a borrowing capacity limit. While that limit may change over time, it’s important to acknowledge that it exists. Borrowing capacity can be constrained in two ways: by banks or by personal circumstances.
Banks are bound by strict credit policies that dictate how much they are prepared to lend. Sometimes, this means you may be financially capable of safely managing more debt, but the bank’s policies prevent you from accessing it.
Alternatively, your borrowing limit may be self-imposed. You might only feel comfortable borrowing to a certain level, or you may prefer not to increase debt because it does not align with your long-term goals, particularly if you are relatively close to retirement.
The key point is that almost everyone faces a ceiling on their borrowing capacity, yet investment opportunities are never in short supply. For example, even if only 5% of Australia’s properties are considered to be investment-grade, that still equates to around $580 billion worth of quality property. In other words, there will always be more than enough opportunities to buy the right property. What’s scarce is not investment opportunities, but the borrowing capacity you need to acquire them.
Measuring return on borrowing capacity
If my borrowing capacity is capped at, say, $1 million, the most important question to ask is: how do I allocate that $1 million to achieve the best possible outcome?
For most people, the ultimate goal is to fund retirement. In that context, the most useful measure is the after-tax return expressed in dollar terms. Percentage returns are helpful for comparing different investments, but what really matters is the actual dollars generated.
I have made this point before when discussing internal rate of return (IRR). While IRR is expressed as a percentage, what it ultimately matters from a practical perspective is the dollars created after all taxes, because that is what you have to spend in retirement.
Illustration of the return of borrowing capacity
I have prepared a financial comparison of four $1 million investment properties, each with the same total long-term return of 9% p.a. The only difference is how that return is split between income and capital growth.
In my view, 9% p.a. is a realistic benchmark for long-term returns. Be cautious if your strategy assumes you can achieve significantly more than this, on average, over several decades. While higher returns are possible in shorter bursts, it’s not reasonable to build a long-term plan on that assumption.
The table below sets out two key measures:
- After-tax monthly holding cost: This represents the investor’s actual cash flow contribution to hold the property.
- Return on borrowing capacity: Net wealth accumulated (after tax, in today’s dollars) – this figure reflects the wealth created after deducting all holding costs and capital gains tax. It is effectively the true measure of return generated by the investment.
This table shows that the mix of income and growth has a significant impact on both affordability and the actual wealth created.
Why not buy two higher yielding properties?
The 2%/7% property costs around $2,100 per month after tax to hold and produces approximately $2.15 million (in today’s dollars, after all taxes) over 30 years. By contrast, the 5%/4% property costs only $1,100 per month to hold but generates just $920,000 after 30 years.
At first glance, you might ask: why not buy two of the 5%/4% properties? That would deliver about $1.84 million – not far off the $2.15 million result of the 2%/7% property.
The key point is this: doing so requires twice the borrowing capacity. If borrowing capacity was unlimited, then favouring higher-yield, lower-growth assets could be a reasonable strategy. However, in reality, borrowing capacity is finite. And like any scarce resource, it must be deployed where it delivers the greatest after-tax dollar returns.
For instance, if your borrowing capacity is capped at $1 million, then allocating it to anything other than a 2%/7% property will result in significantly less wealth creation.
But higher yielding properties allow you to borrow more
Some people may argue that investing in higher-yield properties can help extend their borrowing capacity. It’s true that banks typically include 80-90% of gross rental income (allowing 10-20% for expenses) when assessing serviceability, and this additional income can support a higher loan amount.
However, the impact is relatively modest. Borrowing capacity is usually tested using a 25-year term and an interest rate buffer of around 3% p.a. above the actual rate. As a guide, an extra $100 per week in gross rental income might only increase borrowing capacity by between $43,000 and $48,000. In other words, borrowing capacity is not particularly sensitive to rental yield, unless interest rates are very low.
That’s why I believe targeting a property primarily for yield, in the hope of stretching borrowing capacity, risks being an expensive long-term mistake.
Selling and reallocating borrowing capacity can be a good idea?
Investment property returns can be unpredictable. Markets tend to move in cycles – periods of strong growth followed by flat phases. If you happen to buy just before a growth cycle, you could enjoy the double benefit of high rental yields and strong capital growth. But the key question is whether it’s realistic to expect those conditions to continue indefinitely, or at least for many decades.
If you have enjoyed unusually strong returns but believe future growth will be much lower, particularly if upon reflection, you do not consider the property to be investment-grade, it may make sense to consider reallocating your borrowing capacity into a higher-quality asset.
Take Brisbane as an example. Since the start of 2019, median house price has grown by 9.1% p.a. over the past 6 years. If Melbourne were to deliver a similar growth rate over the next six years due to mean reversion, while Brisbane’s market flattened, then even after factoring in transaction costs such as capital gains tax, stamp duty and buyer’s agent fees, you could still end up accumulating more than twice the after-tax wealth by reallocating your borrowing capacity into Melbourne.
To be clear, I am not suggesting that investors sell high-quality, investment-grade properties after only six years. The point is simply to highlight how critical it is to allocate borrowing capacity wisely. Done well, these decisions can have a considerable impact on long-term wealth creation.
How to maximise your borrowing capacity
There are several strategies to help maximise borrowing capacity – I discussed some of these back in 2023. However, because everyone’s circumstances are different and credit policies change frequently, the most effective approach is to work with an astute mortgage broker. A great broker can identify the factors most relevant to your situation and show you exactly what levers you can pull to improve your borrowing capacity.
Does return on borrowing capacity matter to everyone?
I often hear investors say that if a property is positive cash flow – essentially paying for itself – then there’s no harm in holding onto it. If it grows in value, great; if not, at least it doesn’t cost anything to keep.
That line of thinking is far too simplistic. It ignores the opportunity cost of both the equity tied up in the property and the borrowing capacity it consumes. Conversely, you need to factor in the opportunity cost of a potential large capital gains tax bill if you eventually sell, as I’ve discussed previously.
In my view, a good investor always seeks to maximise risk-adjusted returns. There’s little point in holding an asset if you are not being adequately rewarded for the risk and resources it consumes.
If borrowing to invest is a central part of your strategy, then it’s critical to ensure that this scarce resource is allocated where it can deliver the best outcomes.
