Is your equity working hard enough for you?

Many home owners focus on repaying their home loan as quick as possible. Of course this is often a good idea. Plus, it’s an easy decision when we ask ourselves the question “what should I do with my money to build financial security”. An often more challenging question is what else can/should I do, if anything? And, am I making the most of my opportunities?

Perhaps the most common untapped opportunity is equity. More specifically, borrowable equity. Borrowable equity is the amount of money you can borrow using a property as security. To calculate your borrowable equity you multiple your property’s value by 80% and subtract any existing loan amounts/limits you have secured by that property. For example, if your home is worth $800k and you have a home loan of say $350k, your borrowable equity is $290k (80% of $800k = $640k less existing loan of $350k = $290k). Of course, this assumes you have enough income to support total borrowings of $640k and that the bank values your property at $800k.

This begs the question, what can you do with $290k of borrowable equity?

Let’s keep things really simple. If you are approximately 10 or more years away from retirement then it’s likely that you are still in the accumulation phase of your financial life. This means that you should invest most of your assets in growth assets (i.e. assets that deliver most of their return in capital growth and proportionally less of their return in income). Click here for a previous article I wrote about the importance of investing in growth assets sooner rather than later. There are really only two growth assets to choose from; shares and property. Let’s look at a strategy for each.

A simple share strategy

Firstly, when it comes to investing in shares, I strongly believe in a passive investment methodology as opposed to active management. The difference in simple terms is that active managers try to outperform the market through buying and selling stocks on either a growth (i.e. we think this company is going to do great things) or value (i.e. we think the stock is undervalued) basis. It’s highly subjective and there’s a huge body of long-term statistical evidence that demonstrates that fund managers cannot outperform the market consistently, year-on-year. Also, because the funds have to pay “stock pickers” a lot of money and bonuses, the fees charged by these funds can be very high (often double that of passive funds). A passive investment methodology means that you invest in the “market” or the “index” so that you are always going to get the market’s return. Also, passive funds charge lower fees because they don’t need to pay for stock pickers and there’s less fees and tax because there’s less buying and selling. Here’s an article which tells you more (click here) or just Google “passive investing”. Warren Buffett, for example, is a strong believer and his instructions to the executor of his estate is to simply invest all his estate in index funds (he has left most of his fortune to the Bill & Melinda Gates Foundation but some of his money to his family). In 2008, Mr Buffett made a bet that a simple passive fund would outperform hedge funds over the next ten years. This recent article tells us he’s winning this bet.

A smart investment strategy when it comes to investing in shares might be to set up an investment loan of say $200k secured by your home and invest say $50k in an index fund to begin with. Then, each month you may like to invest say $2k per month into the fund – being $1k from your personal cash flow plus drawing down $1k from the new investment loan. This lets you benefit from a bit of gearing (importance of this discussed here) whilst being relatively low risk by drip feeding your money into the share market regularly. Because the loan is secured by your home, there’s no risk of margin calls and rates are low.

This strategy is very low maintenance. There’s no need to worry about or check stock prices, do research or anything like that. You can set up a regular direct transfer so that the monthly investment occurs automatically. The income distributions from the fund should be around 4% p.a. which offsets most (if not all) of your borrowing costs at this gearing rate. The investment fees on say a $100k investment will likely be only $625 p.a. This is a very low-cost, low-maintenance investment strategy. Here is an example of such an index fund (click here).

Please be warned that the dollar amounts in this example are for illustrative purposes only. You need to decide what’s appropriate for your circumstances after seeking professional advice – from us of course.

A simple property strategy

You could use the new $290k investment loan as a deposit for an investment property – i.e. deposit means 20% of the purchase price plus costs. Allow approximately 10% for costs (stamp duty, buyers’ agent, etc.) to ensure you are left with a buffer. Therefore, a $290k loan will allow you to invest in a property for up to approximately $960k (being $290k divided by 30% = $967k).

Of course, you may not want to spend that much. Firstly, you need to consider your affordability as you may not have sufficient surplus cash flow to service that amount of lending. Secondly, taking into account your circumstances, it may not be a good strategic decision to invest that amount of money. Typically, I advise clients to invest as little as they can without compromising on the quality of the investment. For example, if you have a budget of $300k, it’s likely you are going to have to make some compromises on the quality and purchase a less-than-investment-grade property. However, you don’t need a budget as large as $1 million to ensure you get an investment-grade property either. Even if a client had the capacity to invest in a $960k property (and assuming it’s their first investment), I’d probably encourage them to spend less – maybe something in the range of $450k to $600k in the Melbourne market for example. This might leave room for them to buy a second investment property in a few years’ time. All things being equal, it’s better to have more individual properties for diversification purposes (i.e. better to have four $500k properties than one $2 million property).

Of course, due to the higher level of gearing, this strategy will cost more in terms of cash flow than the above share strategy. I estimate that at current variable interest rates a $600k investment property will cost your approximately $550 per month after-tax in cash flow (assuming a 4% rental yield).

One of the perceived disadvantages to property investment (compared to shares) is that you are forced to invest a large sum of money at once whereas with shares you can invest smaller amounts more regularly. I consider this as both a disadvantage and an advantage. It’s an advantage because the more you invest, sooner, the better off you’ll be in the long run due to compounding capital growth (again, see my previous article). Assuming it is safe and sensible to do so, property forces people to invest more now.

What suits you?

Some people are very comfortable with focusing solely on repaying their home loan before they turn their attention towards investing. That approach is completely fine so long as people recognise that there’s a cost with this approach in that you are using up one of the scarce ingredients required for low-risk investing being time. The more time you have, the less aggressive you need to be (i.e. lower risk). The aim of this article is to educate you that utilising your equity won’t necessarily impinge on your ability to repay your home loan quickly i.e. you can do both at the same time.

If you are interested to find out more, please contact us (by phone on 03 8624 4600 or email) for an obligation-free conversation to discover if you are making the most of your opportunities.